Robert T. Smith: A Non-banker’s Perspective

Editor’s note: Robert Smith is a partner in the Friday Law Firm’s Mergers & Acquisitions Practice Group. His corporate practice focuses on representing individuals, companies, and financial institutions in general business, transactional, securities and regulatory matters. Talk Business & Politics asked him to share his thoughts on the banking landscape in Arkansas.

Q: Arkansas bank profits have been consistently higher over the past several years, according to FDIC statistics, yet we continue to hear about regulatory burdens squeezing profits. How have you seen the bigger banks adapting versus the smaller banks to these regulatory burdens and is it as bad as we hear?

Robert Smith: While bank profits have been higher, it is in spite of new regulations. Banks had nowhere to go but up after the impact of 2008 and 2009. Although you could not convince Elizabeth Warren of this, it is ridiculous to say that the new regulatory environment does not disproportionately impact community banks as compared to their larger rivals. Over the past several years the regulatory changes have slowed banks’ ability and willingness to make mortgage loans, in addition to the significant increase in compliance costs.

It is also short-sighted to see the rebound in profits and declare that community banks have successfully withstood the regulatory avalanche. I recently read that the average community bank (defined as less than $1 billion in assets) has fewer than 40 total employees. That includes everybody, tellers, secretaries, loan officers, etc. The economies of scale simply do not exist to allow those smaller institutions to maintain profitability at a level that their shareholders and potential investors will accept. The time horizon to assess the impact of this new environment has to be longer than just a few years.

Your question asked how larger banks have adapted. I have observed that they are simply in a better position to address the compliance issues because they have the capacity to add personnel, training, etc. This then obviously puts enormous pressure on small banks leading, in many cases, to the decision to sell. Arkansas is fortunate to have many well-run institutions. The larger institutions (several billion dollars plus) have looked around the southeast region and taken advantage of acquisition opportunities. Small well-run banks have taken advantage of the opportunity to grow above the $500m and $1b level through mostly in state acquisition.

Q: We’ve seen significant merger and acquisition activity in the market. What type of M&A activity do you sense we will see more of in the next year to 3 years?

Smith: I believe the pace will continue to slow when compared to the past 4-5 years of activity in Arkansas. However, we will still see plenty of active interest in evaluating deals (and many behind the scenes as banks test the waters and search for acquisition partners). The Bank Director publication recently released an M&A survey indicating that around 2/3 of banks believe that the current environment for transactions is more favorable than last year. One of the factors cited was continued improvement in credit quality. While this makes the due diligence process less of a headache, many smaller institutions still have unrealistic visions of higher valuations relative to book value that will make a transaction less likely.

The Federal Reserve also recently revised its policy regarding small bank holding company acquisitions that will expand financing options to more institutions. The Fed’s Small Bank Holding Company Policy Statement, adopted in 1980, has applied to holding companies with consolidated assets of $500 million and less. Institutions of that size are allowed to incur higher levels of acquisition indebtedness than permitted for larger companies. Last month, the Fed increased the asset level to $1 billion, thereby allowing more bank holding companies to debt finance up to 75% of the purchase price of a target bank.

Q: Do you have any prediction as to what may happen with some of the smaller banks in Arkansas – ones with aging boards, shrinking loan activity and/or deposit base, smaller communities losing population? Will someone buy these banks or do they shrink to the point of closure?

Smith: Having grown up in a small town in southwest Arkansas, I share the concern of the dwindling numbers of small town banks. These institutions serve an important role in the community by providing credit access to otherwise unserved borrowers and supporting local schools and community groups. We have a surprisingly high number of institutions in the State that serve only one or two small towns.

Your question identified a significant problem relating to aging boards. In this environment, any community banker can attest that it is far more difficult to recruit new board members that do not either own a significant stake in the bank or have some other associated family history with the institution. Director liability concerns are more prevalent now than seemingly ever and for good reason. Regulators too often apply 20/20 hindsight to a board’s actions. Compounding the board issue is an increasing number of absentee owners. As family held shares pass to later generations, many of whom have moved out of the local community, there is simply less involvement and concern for the well-being of the bank and the local community. When considering a sale, in my experience these detached shareholders often have wildly unrealistic visions of the value of the bank’s franchise, which further exacerbates the problem in attempting to structure and complete a transaction.

A few positive trends may be at work in Arkansas however. We are seeing a number of small bank clients working to grow to reach the $500 million or $1 billion level to achieve some economies of scale. There are also instances in which investor groups desiring to enter the banking industry have located a well-run small bank looking to inject capital and build out the bank’s market by branching into other areas. Although the freeze on de novos has begun to thaw, the reality is that it is faster, simpler and more likely to obtain regulatory approval for investors to acquire an existing bank than start a new charter.

I hate to consider that we would see small banks simply wither out of existence. I believe this is unlikely given two factors that would ultimately impact valuations in those situations. First, at some point (in most cases), shareholders will see the handwriting on the wall and look to realize the best return available. While the multiple may not be as high as hoped for, even a limited return on investment would be better than the alternative. Secondly, the regulatory agencies are good at keeping tabs on institutions headed in the wrong direction. For a truly troubled institution, they can exert a significant amount of influence when considering the bank’s options.