By Jeffrey P. Marsico, President, The Kafafian Group, Inc.
The US banking system is unique in its history and industry structure. The incredibly shrinking US banking landscape is probably no surprise to the rest of the world. At the end of 2021, the United States had one FDIC (Federal Deposit Insurance Corporation)-insured bank for approximately every 68,000 people. The United Kingdom had approximately one monetary financial institution (MFI: banks and building societies) for every 185,000 people.
Consolidation should not surprise anyone. But in many US circles, consolidation feels overdone, especially since we had more than 15,000 FDIC-insured financial institutions in 1990 and are now below 5,000. Where is the bottom?
At the height of US bank mergers in 1997, there were 725 merger deals. But offsetting this were 199 new banks or de novos opened. In 2021, there were 215 bank M&A (merger and acquisition) deals, representing 4.3 percent of all FDIC-insured institutions. Eight de novo charters were granted.
Why have US investors abandoned starting new banks? A compelling argument could be made for competition. Change is happening at historic levels in banking. What used to take more than 10 years for adoption—think the ATM (automated teller machine)—is now happening in less than two—think mobile banking. How will a very small financial institution be able to make the investments brought to market by Goldman Sach’s Marcus (backed by a $115-billion market cap owner) or Chime (funded by seven rounds of private equity totaling $2.3 billion)?
Another case could be made for regulation resulting in fewer de novos. How can a small financial institution obey the letter and spirit of the law and the myriad of regulations spawned from those laws in as efficient a manner as a financial institution 10 times, no 100 times, its size? Many existing banks cite the regulatory environment as the main reason they sold. The politicization of regulatory bodies only exasperates the situation. Ask those regulated by the New York State Department of Financial Services (NYSDFS). It should be no surprise that the executives that decided to sell their financial institutions due to onerous regulations are hanging up their cleats rather than organizing a new bank.
And for sure, both change and the regulatory environment play a role in the dearth of new bank-charter applications. But there is at least one other—one not mentioned as frequently, but that might be the single greatest obstacle to new bank formation in the United States:
Math
If a bank has a business model that is unique or serves a narrow constituency, regulators push back in the name of concentration risk or untried business models. I recall an internet bank that was trying to get off the ground in Michigan in the late 1990s. The concept was new, and growth was projected to be robust, albeit not off the charts. The FDIC required the bank to raise $20 million in capital, a tidy sum back in the 1990s when banks started with less than half as much. Because the business model was unique at that time, the regulators required a relatively high level of capital. The bankers couldn’t raise it, and the de novo never got off the ground.
Today, regulators are more open-minded… a little more. Varo Bank, NA, which Varo Money sponsored—the fintech started in 2015, undertook a three-year quest to obtain a bank charter. It succeeded in 2020. Their chief counsel stated, “It takes a lot of patience because it’s a very long, fairly complicated process and requires a tremendous amount of back and forth with the regulators.” Varo capitalized its bank with more than $120 million and added a second round of more than $400 million in the third quarter of 2021. Barrels full of capital open minds.
But what of the traditional de novo banks? So far this year (through mid-year), seven banks have received charters, and 11 banks have applied, excluding one application that was a special purpose charter of an existing financial institution. Of the 11 that applied, the average capital sought to open was $26 million for those that disclosed it, a far cry from Varo’s fundraising. What was the pitch to those investors for the $26 million? Here lies the math problem.
Investor pitch
Let’s say an investor group, tired of big banks making decisions about their communities hundreds of miles away, decides to explore starting a bank. They put together an outline of a business plan, project out their financials for several years, and visit the FDIC.
The FDIC looks at the business plan, critiquing any part of it that is outside the norm, serving a particular industry or industries, relying on non-traditional distribution methods, and so on. They suggest that being more plain vanilla will increase their chances of approval. And by the way, it will require $26 million in startup capital, the average capital raised for new banks this year. The investor group puts together a prospectus and begins soliciting shareholders for commitments.
Joe Investor has $10,000 to invest. Does he put it with this new bank? Or does he invest in an S&P 500 Index Fund? The S&P 500 has had a compound annual total return of 9.3 percent over the past 10 years and 9.4 percent for the past five years. So, Joe Investor projects an S&P 500 compound annual growth rate of 9.3 percent for the next 10 years.
For Startup Bank, the organizers have projected the following over the next 10 years:
A $10,000 investment in a de novo bank returns 24 percent less than the return Joe Investor could receive by investing in an S&P 500 Index Fund. And if Joe needs his money out of the fund, he places his trade, and the money will be in his bank account within three days. Startup Bank, on the other hand, would likely trade very little. For all US publicly traded banks between $250 million to $1 billion in assets, the average trading volume is 2,200 shares per day. Joe’s sell order on his holdings could move the market and decrease his value. There are no such worries when investing in a fund. That is one reason institutional investors own more than two-thirds of all US bank shares. Individual investors are choosing funds.
Business regeneration is a hallmark of healthy economies. There are advantages to having decision-makers reside in or very near the markets where their borrowers live and work. There is a deeper understanding of the nuances of granting credit. Imagine a credit analyst working hundreds or thousands of miles away from an Amish farmer borrower and reviewing that credit application. “They want to borrow how much against how much in income?” Whereas the local banker knows that the loan is golden. The farther away the borrower from the decision-maker, the less likely character will play a meaningful role in the credit decision, and the more difficult it will be to fund early-stage or nuanced businesses, which inhibits business generation.
Perhaps the above projections for Startup Bank will no longer be the norm. Fintech (financial technology) business models typically call for significant amounts of capital accompanied by several years of operating losses so they can achieve scale quicker. Startup banks, on the other hand, are required to submit three-year business plans that demonstrate a profit by the end of the projection period. That requires the bank to strive for profitability far earlier than achieving critical mass to deliver solid returns to shareholders.
The antithesis to the traditional de novo path, American Challenger Bank NA applied for a charter in July 2020, pledging to raise $750 million in capital. Instead of taking the traditional approval path, it pivoted and agreed to merge with Patriot National Bancorp Inc. in November 2021. That transaction was conditionally approved by the Office of the Comptroller of the Currency (OCC) in July, conditioned on, among other things, Patriot raising $875 million in capital.
This is clearly more fintech-like, raising eye-popping sums of money to scale rapidly. Will this be the new norm? After American Challenger Bank NA and Patriot National received conditional approvals, they terminated their deal. The conditions were too onerous. So, I’m skeptical it will be the new norm. And it is unclear if fintechs will enjoy lofty valuations once they become banks. LendingClub, which acquired Radius Bank in 2020, now trades at 1.3 times book value and less than 10 times earnings. These are bank-like multiples. All this puts a damper on fintechs becoming banks.
There is an economic case to be made, however, for traditional de novo banks. But lest you think that the dearth of de novo banks is a regulatory or industry-change problem, I have news for you. It’s a math problem.