As the chart below graphically depicts, de novo bank charters have all but disappeared from the banking industry landscape coming out of the financial crisis. Between 2000 and 2008, new charter formation reflected on average more than 150 institutions entering the banking sector PER YEAR. Since 2011, six new bank charters have been granted, with half of those coming in 2011 alone. Are de novos dead? Do the economics even make sense to support new bank start ups? Is the market euphoria post-election in bank equities signaling a potential return to increased de novo applications in the future? Are technological forces, prospective regulatory rollbacks, anticipated tax reform, and probable interest rate relief, possibly coalescing to finally create an environment supportive of new bank formation?
Currently, there are five de novo banks in organizations across the country. However, four of those institutions are based in Southern California, while the fifth calls Oklahoma home. Not exactly a surge of activity, but potentially a precursor of things to come. Looking at some of the dynamics that have shaped de novo formation in the past (industry consolidation, access to management talent, certain markets possessing compelling demographics, etc.) simply confirms the continued existence of the same comparable attributes. It has largely been the result of a challenging year-after-year low interest rate environment (remember, even in normal operating environments, de novos typically take roughly 24 months before they turn the corner), and the shifting regulatory pendulum coming out of the financial crisis, coupled with bank stock valuations enabling investors to buy seasoned organizations at or below tangible book value, that have proven to be the major impediments to new bank charters once again dotting the landscape.
So what has changed, or is expected to change? Well, succinctly, the expectation of material corporate tax reform should serve to lift the earnings prognosis for all banks. The equity markets have already begun to adjust to this potential reality, driving bank stock prices significantly higher in the weeks following the Presidential election. Interestingly on this front, while the knee-jerk reaction may lean toward the belief that bank stocks may be getting ahead of themselves, a back of the envelope assessment of the simple impact of effective tax rates declining from approximately 35 percent to something in the neighborhood of 15 to 25 percent would seem to largely reflect that relative P/Es pre-election are still fairly consistent with forecasted P/Es post-election after adjusting the tax line.
That leaves us with looking at another potential material contributor to banks’ earnings profiles in the form of higher interest rates. Intuitively, the existence of a modestly higher and steeper yield curve clearly represents a more favorable operating environment for a management team looking to leverage new equity and build a formidable organization. It is not, however, the end all be all for guaranteed profitability. An adherence to sound credit quality and appropriate loan portfolio diversification, cultivation of traditional core funding, prudent exploration of select alternate revenue streams to augment core margin income, and fastidious control of operating expenses and development costs, will continue to be mission critical to building a sound and profitable institution.
And, technology has largely enabled many banks to compete with institutions of any size. Utilizing and leveraging the R&D of larger banks over the years has helped position many community banks to effectively pivot from the belief of needing to be “cutting edge” in technology in order to be competitive, which at times simply translated to some shops being “bleeding edge” when assessing their resultant profit dynamics. And, a de novo today does not necessarily need to early on direct a lot of energy into a branching strategy. Branches are far from obsolete, but their focus and utilization are changing dramatically as just about anyone with a phone/computer has the ability to “visit” a branch at their fingertips.
On the regulatory front, anticipation of regulatory relief or at least a meaningful rollback of costly post-crisis requirements (particularly at the community bank level), bodes well for the de novo model. However, two things immediately come to mind. First, regulatory relief, if and when it occurs, will not come overnight. Particularly with the overhang of the Wells Fargo account opening scandal on the industry at large, and its lingering effects on consumer sentiment toward bankers in general. And second, de novo organizations already are required to operate in the early years within an environment of higher capital levels and increased regulatory scrutiny, simply and rightfully so because of the risks inherent in the development of any new organization (but clearly heightened coming out of the recent financial crisis). So check the box on tax reform, pencil in the expectations of a more favorable interest rate environment, but put a prominent “TBD” next to the regulatory question.
Bottom line, these organizations are not launched in a vacuum. Community support is important, but investor interest is critical, both in terms of attracting the initial capitalization (which many now peg at a minimum of $25 million) and as a source of future equity and/or quasi-equity as the institution grows. There is no doubt that it is not solely Southern California communities that would welcome a new bank charter with open arms, but candidly a traditional de novo has not exactly represented a truly compelling investment in recent years. The operating environment has been difficult. Through the crisis the failure rate of recent de novos was significantly higher than older community banks. And the stock prices of seasoned institutions often already reflected the opportunity to buy an existing bank at or below its tangible book value. Consequently, the math involved in trying to attract investor interest in a de novo that typically experiences an instantaneous decline in book value the day it opens and then often hemorrhages for maybe another two years before turning profitable was, quite simply, not adding up.
That, however, may finally be changing. Do I anticipate a return to the halcyon days of 100-plus new banks entering the industry’s new ranks each year? No. But do I believe that in select cases, with the right management teams, in good markets, that the investment potential of a de novo may once again be compelling? Yes. Decidedly yes. And after seeing so many communities across the landscape witness the disappearance of their local institutions over the years, I for one would welcome the rebirth.
As 2016 draws to a close, I wish all of you and your families a happy and safe holiday season. I recognize that each of you, to varying degrees, are assessing and addressing the challenges of the existent interest rate environment and its attendant margin pressures, the competitive conditions that continue to escalate on both sides of the balance sheet, the potential implications of CECL coming on the heels of more stringent capital requirements, the potential implications of breaching stated CRE concentration thresholds, possible succession considerations as you and your Board look to the future, and the increased regulatory burden across just about every aspect of your business. Please do not hesitate to reach out to me and/or my colleagues at Austin Associates if we can be of assistance as you take your organization forward. Best wishes for continued success in 2017!