Where will banks get their next dollar of capital?

Retained earnings.

I make a living helping financial institutions be as profitable as feasible. Why? To perpetuate their business model. This is how I feed my family.

But profits have been under pressure since 2008. First, FIs experienced pressure in their investment portfolios, purchasing Fannie Mae preferred's and other FIs trust preferred securities. Next, our over-exposure to construction and land development loans came to roost. Then commercial real estate fell under pressure as the economy teetered and rent roles declined.

Many banks had to replenish lost capital. The government stepped in to help, and taught us to ignore the guy/gal that knocks on our door and says "I'm from the government, I'm here to help." Absent or in concurrence with government-injected capital, FIs sought fresh capital.

But retail investors were nowhere to be found. This was one of the points made by Lisa Schultz of Stifel, Nicolaus, Weisel, an investment banking firm that specializes in FIs, at a recent Pennsylvania bankers conference.

Ms Schultz said retail investors were absent for all industries, not just FIs. She opined that they opt instead to invest in mutual funds, hedge funds, etc. Therefore, all of the action to attract capital was in the institutional market. I made this point in a past blog post, opining that the change in our shareholder base would be a significant factor driving future bank consolidation.

The change in shareholder focus, as presented by Ms. Schultz, is represented in the tables below. But this changing focus is from the institutional shareholder perspective... not the retail investor. The future investor will be concerned with quality growth that enhances shareholder value, combined with dividend policies that are mindful of capital preservation. I'm not sure how an FI will meet the 20%-30% capital appreciation, combined with sufficient liquidity, to meet "future", i.e. institutional, investor demand.

As if the shifting focus of the institutional investor wasn't challenging enough, what about the difference in what retail versus institutional investors value, and how they plan to exit their investment (see table below).

Tough luck finding your institutional investor at the local coffee shop bragging that they own stock in your institution. They could care less about how much resources your FI dedicated to the local food bank.

Here is what I think community FIs can do now to prepare for this shift in attitude:

1. Maximize retained earnings to reduce the need to visit the capital markets.

We have gotten a multi-year pass in generating profits because of the financial crisis and the subsequent teetering economy. Now it's time to cowboy up. How productive are your front line employees? How efficient is your back office? How well have you leveraged technology? Have you over-reached with your compliance program? If you don't have the answers, you better start looking for them.

2. Get a real investor relations program.

Investor relations is marketing. Marketing is much more than advertising. And your marketing message must be delivered long before you ever need capital. You must spin a story that gets locals excited about your bank. Yes, financial performance will play a significant role, but a supporting role to the story you tell about how your FI is a critical component to local communities. Retail investors may have shifted to investing in mutual funds, but the local community bank is probably one of few chances locals can invest in a company down the street.

3. If you must tap the institutional market, choose your partners carefully.

Ms. Schultz specifically addressed this issue in her presentation. Search for institutional investors that share your FIs objectives. Where did this fund invest? How long did it hold the investment? How did it exit?

4. Prepare for the exit strategy from the time of investment.

Receiving significant institutional investor dollars does not mean a fait accompli in terms of having to sell your FI so the investor can get out of the stock. However, if you don't plan for the investor's exit when they make their investment, the clock may run out when they are ready to go. Make evaluating strategic alternatives a regular part of your strategic planning, developing financial projections for a stretch case, base case, and stress case. See my post on this subject here. Also, make financial performance, investor relations, and stock trading liquidity a part of your strategy from the git go. If not, you'll find your FI might have up and went.

Where will your FI get it's next dollar of capital? I would like to know.

~ Jeff

The coming bank consolidation... but not why you might think.

If I had a nickel for every time an investment banker predicted the mass consolidation of our industry I could buy a free round to all attendees at next month's Financial Managers' Society Forum. Financial Institutions need greater scale to offset the rising regulatory burden imposed by Dodd-Frank and soon to be imposed by the Consumer Finance Protection Bureau (CFPB) is the most often cited reason.

But I have noticed a couple of trends that may be a better leading indicator of coming FI consolidations, one old and one new.

Old

The old reason is that our CEOs are old... pun intended. Prior to the 2007 financial crisis, we prognosticators used to look at CEOs age as an indication of whether a financial institution would sell. See the table for the average age of FI leadership for publicly traded banks and thrifts.  It tells a challenging story... one quarter of FI CEO's are two years from retirement. Half are seven years away. Are there successors in the wings?

I have not read one press release announcing a merger that stated: "Our CEO is old, we have nobody to replace him, so we sold." But the cynic in me says this reason stands tall in prominence in the Board meeting when the sale decision is made.

This could be because the CEO does a good job, and neither the CEO or the Board thinks there is another potential CEO candidate that can do as well. If this is the case, then I put to you that neither the CEO nor the Board has done a very good job of developing leadership in the organization making successful next- generation passing of the baton doubtful. The cynic in me suspects there may be no opportunity for the retiring CEO to unlock the value of his investment in the FI without a sale.

But there are exceptions, such as how Wayne Bank in Honesdale, Pennsylvania implemented a leadership change flawlessly. Bill Davis, a great banker who never thought the success of the bank was all about him, moved out of the executive suite on retirement day and passed leadership to his second in command, who had been groomed from within. See the link below for the jfb post on Bill Davis.

New

The newfangled reason for the coming consolidation wave, in my opinion, is the change in our shareholder base (see chart). Community FIs used to have very predictable shareholders. They were typically within our communities, liked the dividend, and were proud to own a piece of their local bank.

Having gone through a few consolidation waves, our shareholders have become more diverse. They're also becoming older, and many have already passed shares to the next generation that lacks that same connection to the bank.

Lastly and possibly more importantly, FIs have needed capital during the past few years as loan problems and operating losses have reduced industry capital ratios. We turned to the most prominent underwriters of community FI stock, Sandler O'Neill, KBW, and Stifel to replenish our capital coffers. Where do these underwriters place the community bank issues? With institutional shareholders such as asset managers, hedge funds, and the like.

These institutional shareholders have little interest in what you think you mean to your communities or employees. They plug in the number they bought into your shares, and expect a certain return. If you can't deliver the return via profitability, then you better sell to give it to them. These shareholders at times own a relatively large percentage of a stock that doesn't trade heavily. In these instances, it would be difficult for the institutional shareholder to exit the stock through any other means than a sale.

Yes, those that successfully raised capital in the past two years are proud that they have done so. But I wonder if, while basking in the glow of that success, they understand that they may have sealed their fate far in advance?

Do you think there will be an increase in FI consolidations? Why or why not?

~ Jeff

Ode to Bill Davis:

http://jeff-for-banks.blogspot.com/2010/02/ode-to-bill-davis.html