Bank Board Letter August 2014 : Page 1

The BANK BOARD Letter Edited exclusively for directors of financial institutions and their holding companies August 2014 A New Source of cApitAl for commuNity BANkS By Joshua siEgEl A bout three years ago, I was at a meeting where senior of-ficials from the American Bankers Association relayed a problem that had been communicated by their community bank members. Having exhausted the financing options that local investors traditionally provide, community banks were also being turned away by investment banks that were unable to engage in smaller-sized mandates. In addition, trust-preferred securities, an efficient and non-dilutive method of raising capital outside of a bank’s local market, effectively disappeared due to regulatory and market dynamic changes. The community banks looked to the ABA for help in their capital-raising efforts. Around the same time, the Treasury Department received an executive mandate to lower the barriers to capital for communi-ty banks. What had prompted the White House to take action on behalf of community banks? And where was this seemingly sudden demand for unavailable capital coming from? I quickly found the answer to my questions: banks with less than $10 billion in assets, while representing less than 20 per-cent of total bank assets, have extended nearly 60 percent of the nation’s small business loans made by banks. But now, regula-tory changes were requiring all banks to hold increased levels of capital, and community banks’ conventional capital investment resources were already accounted for or no longer available. Increased capital requirements combined with capital inac-cessibility was limiting their growth. This dynamic was hinder-ing small businesses’ ability to get loans and create jobs. The collective result was a hit to the American economy and direct impact on local economies. Image courtesy of Chad Baker/Thomas Northcut/Thinkstock. . Solving A $50 billion problem We estimate that the community banking sector will require more than $50 billion of capital over the next several years to facilitate these heightened regulatory capital ratios alongside of organic growth, acquisitions, share repurchases and other refi-nancing activities. So how could we bring capital to America’s healthy small banks so they can continue to help their communities thrive? We decided to take a management consultant approach, starting with the solution and working backwards. The solution had to satisfy three constituencies: the banks, the investors and the regulators. We found that banks and regulators wanted the same thing: permanent, passive and reasonably priced capital. Hedge funds, with their need for liquidity, are certainly not per-manent sources of stable equity capital. Private equity funds take a longer view, but their limited partners demand returns in excess of 20 percent, certainly not what community bankers would consider reasonably priced capital. Retail and passive institutional investors, however, would be very happy with a single-digit yield. So how could we aggregate such a diverse group of com-munity bank assets for investors? Similar to the evolution Premium DigitAl content: 1. Bank-owned life insurance: a Primer for community Banks 2. Loan Officers Report Easing of Standards 3. Duration Analysis Helps Manage Interest Rate Risk 4. Bankers Focus on Improved Customer Experience 5. FDIC Publication Focuses on Regulatory Responsibilities

A NEW SOURCE OF CAPITAL FOR COMMUNITY BANKS

Joshua Siegel


About three years ago, I was at a meeting where senior officials from the American Bankers Association relayed a problem that had been communicated by their community bank members. Having exhausted the financing options that local investors traditionally provide, community banks were also being turned away by investment banks that were unable to engage in smaller-sized mandates. In addition, trust-preferred securities, an efficient and non-dilutive method of raising capital outside of a bank’s local market, effectively disappeared due to regulatory and market dynamic changes. The community banks looked to the ABA for help in their capital-raising efforts.

Around the same time, the Treasury Department received an executive mandate to lower the barriers to capital for community banks. What had prompted the White House to take action on behalf of community banks? And where was this seemingly sudden demand for unavailable capital coming from?

I quickly found the answer to my questions: banks with less than $10 billion in assets, while representing less than 20 percent of total bank assets, have extended nearly 60 percent of the nation’s small business loans made by banks. But now, regulatory changes were requiring all banks to hold increased levels of capital, and community banks’ conventional capital investment resources were already accounted for or no longer available.

Increased capital requirements combined with capital inaccessibility was limiting their growth. This dynamic was hindering small businesses’ ability to get loans and create jobs. The collective result was a hit to the American economy and direct impact on local economies.

SOLVING A $50 BILLION PROBLEM
We estimate that the community banking sector will require more than $50 billion of capital over the next several years to facilitate these heightened regulatory capital ratios alongside of organic growth, acquisitions, share repurchases and other refinancing activities.

So how could we bring capital to America’s healthy small banks so they can continue to help their communities thrive? We decided to take a management consultant approach, starting with the solution and working backwards. The solution had to satisfy three constituencies: the banks, the investors and the regulators.

We found that banks and regulators wanted the same thing: permanent, passive and reasonably priced capital.

Hedge funds, with their need for liquidity, are certainly not permanent sources of stable equity capital. Private equity funds take a longer view, but their limited partners demand returns in excess of 20 percent, certainly not what community bankers would consider reasonably priced capital. Retail and passive institutional investors, however, would be very happy with a single-digit yield.

So how could we aggregate such a diverse group of community bank assets for investors? Similar to the evolution of real estate investing, where demand for owning buildings shifted to investing in private REITs and finally to investing in public REITs, we sought an analogous structure for bank investments.

This investment vehicle, StoneCastle Financial Corp. (NASDAQ: BANX, www.stonecastle-financial.com), is the first of its kind focused on investing in community banks. Investors get access to a diversified, exchange-traded community bank investment; in turn, community banks get access to a new pool of permanent, passive and reasonably priced capital.

THOUSANDS OF ELIGIBLE COMMUNITY BANKS
What kind of banks does StoneCastle Financial Corp. invest in?

StoneCastle focuses its investments on community banks that have experienced management teams, stable earnings, sustainable markets and growth opportunities. Over the years we have found that smaller banks are reflections of their local markets. Therefore we seek to avoid banks in challenged markets or banks heavily tied to one local industry.

Some think small banks are risky banks, but history suggests otherwise. Since 1934, the worst failure rate for banks and thrifts was 3.2 percent in 1988, and our research has shown that there are more than 6,000 banks that are profitable and well capitalized with an average return on equity of 9 percent.

STONECASTLE’S FOUR-STEP INVESTMENT PROCESS
Upon a bank’s indication of interest, the StoneCastle team will initiate a four-step investment process: pre-screening, due diligence, investment committee analysis, and documentation and funding.

1. First is a pre-screen review of publicly available data to determine if proceeding to due diligence is warranted, and if so, StoneCastle sends a questionnaire to be completed by the bank.
2. Next, StoneCastle performs due diligence including management interviews and background checks; and loan, security and deposit tape reviews.
3. The investment committee reviews due diligence information and determines if investment is suitable. Upon a unanimous decision by the investment committee, StoneCastle then proceeds to final diligence and closing.
4. Upon approval, StoneCastle will execute a letter of intent, draft and sign definitive agreements, and invest funds into the bank.

LONG-TERM CAPITAL PARTNER
Many community banks with well-established franchises and cash-flow characteristics are not attracting capital from private equity or other institutional investors for a number of reasons. Many investors historically have avoided investing in community banks due to the small size of these banks, their heavy regulation, Bank Holding Company Act ownership restrictions and the perception that community banks are riskier than larger financial institutions. In addition, many investors lack the necessary technical expertise to evaluate the quality of the smalland mid-sized privately held community banks.

The StoneCastle team has been investing in community banks for more than a decade and is considered one of the largest investors in community banks. Unlike private equity or many other institutional investors, StoneCastle views itself as a long-term partner that understands the needs of community banks. We believe that our flexibility to make investments with a long-term view and reasonable return requirements makes us the ideal investor for community banks and a solution to a $50 billion problem.

Joshua Siegel is chairman and CEO of StoneCastle Financial Corp. For more information, visit StoneCastle-Financial.com.

Read the full article at http://omagdigital.com/article/A+NEW+SOURCE+OF+CAPITAL+FOR+COMMUNITY+BANKS/1786110/221466/article.html.

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