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Investors say US banks can stay under $1B and still deliver profits

As banks feel pressure to merge and gain scale, some investors suggest banks can stay small, maintain their independence and still deliver solid, sustainable returns.

At a pair of conferences in Dallas the week of April 8, investors told bankers to ignore conventional wisdom that banks need at least $1 billion of assets to defray regulatory costs.

Banks can find ways to raise capital and deliver profits while staying well below the $1 billion threshold, they said. On the expense side, banks can mitigate technology costs by renting solutions from third-party vendors, which charge less for smaller institutions. To stay small and independent, bank executives need to cultivate the right shareholder base and deliver on stated growth or profit targets, investors said.

"Banks need to sit down and visit in detail, not just with their investment bankers but with investors, too," said Dory Wiley, CEO of Commerce Street Capital, in an interview at his company's 17th annual conference. He said banks need to ask private equity firms not just the length of the fund's life but also when it launched to get a sense of when the investor will be seeking a liquidity event. Depositories need to be particularly careful with funds focused on internal rate of return, or IRR, goals, as those funds will often push for a sale since that often generates the largest return, he said.

Wiley also said banks should be skeptical of passivity agreements — contracts that allow an investor to buy a large stake without having to register as a bank holding company by pledging to only have a passive role in the bank. Since the 2008 crisis, investors have flouted those agreements, wielding control on banks' boards while regulators have failed to properly enforce the contracts, Wiley said.

"[Banks] don't notice it until they are already in bed with these guys," Wiley said. "The only time regulators enforce it is if the bank fails. The whole passivity thing has been a farce."

At S&P Global Market Intelligence's annual community banking conference, also in Dallas, a panel representing the investment community urged small banks to find shareholders that are willing to buy into their brand of banking. The right type of investor will have little trouble allowing a community bank to stay small, investors said.

Joseph Stieven, CEO of Stieven Capital Advisors, compared bank performance to classic cars, saying many banks seek to be steady, well-performing Cadillacs that cruise at 60 miles per hour no matter the obstacles. By contrast, other banks will emulate a Ferrari, seeking rapid growth.

"If you're going to be a good, solid company — nothing flashy — then make sure you get investors who appreciate what you are," Stieven said. "You have to execute on what you tell people."

Wiley agreed with the sentiment, saying too many banks seek steady, unspectacular growth but then attract investments from IRR-focused funds that push for outsized returns. Wiley said banks should focus on delivering consistent growth to their per-share figures for earnings and tangible book value.

Other speakers at both conferences said sub-$1 billion banks could take better advantage of certain tools to drive stronger returns. For example, regulators allow small banks to issue debt at the holding company level and downstream the funds to the banking subsidiary for use as capital. The bank can use those funds to pursue acquisitions or enhance shareholder returns with a buyback, among other uses.

"If you pay senior debt rates and can use it as capital, your [return on equity] goes through the roof," said David Sandler, co-head of investment banking for Sandler O'Neill + Partners. "It's shocking that more banks aren't using it."

Kroll Bond Rating Agency Inc. has taken an active interest in rating debt issued by community banks after an analysis showed some community banks deserve investment-grade ratings. That has allowed some small banks to issue debt that costs less than 6%, which translates to an after-tax cost in the low 4% range. Van Hesser, senior managing director for the agency, said appropriately managed banks under $1 billion in assets can earn investment grades. He drew the line at $500 million in assets, saying banks under that level would have to lay out a compelling case for how they have diversified their risk to earn an investment grade.

But even banks that cannot earn an investment-grade rating might be able to find a buyer for their debt. Heather Ceresini, managing director for EJF Capital LLC, said the investment company will buy unrated bank debt. She said the "vast majority" of debt the company has purchased is from banks with at least $300 million in assets, but she added that EJF Capital has done deals for well-capitalized banks as small as $150 million.