Now is not the best time to open a new bank.
Industry observers and even the heads of some of the newest banks in the region all point to cutthroat competition, unusual economic realities, and what could arguably be described as a bank valuation “bubble” as reasons they’d pass on forming a new bank from scratch today and wait for a rosier tomorrow.
Yet the news for the past few months has featured a story about a new community bank opening, or a smaller bank being acquired by a larger one, almost every other week. That’s due in part to the fact that many banking decisions were made a year ago, before economic forces started to go sideways. Huge population, business and job growth in the region, along with a chance to play in a state that is one of the largest economies in the world, have also made for many an optimistic feasibility study. Even though everyone wishes things could be better, confidence is still running high.
What we’re witnessing now is a unique window into the forever repeating cycle of the banking industry. For local businesses, it means money is both cheaper and more available, and banking in general is becoming much more convenient.
Here’s a quick rundown of players, old and new, that have made news on the banking scene over the past several months.
First, in mergers and acquisitions, World Savings Bank and Western Sierra Bank merged into Wachovia Bank and Umpqua Bank, respectively, last year. This year, Sterling Financial Corp. of Spokane, Wash., completed a $335 million acquisition of Sonoma National Bank and announced a $192 million acquisition of North Valley Bancorp of Redding. As of April, the pending merger of Placer Sierra Bank into Wells Fargo had been approved by the Federal Reserve Board and was one shareholder vote away from becoming final.
“The growing number of community banks is making for a very dynamic and competitive marketplace.”
— Bruce Rossignol, vice president, Keefe, Bruyette & Woods Inc.
On the community banking front, new players include Folsom Lake Bank, Commerce Bank of Folsom, Pacific National Bank, Elk Grove Commerce Bank, Community Business Bank and Community 1st Bank, among others.
“This is a pretty active time in Sacramento,” says industry analyst Bruce Rossignol, vice president with investment bank Keefe, Bruyette & Woods Inc. in San Francisco. “Merger activity has been on the rise, and the growing number of community banks is making for a very dynamic and competitive marketplace.”
Rossignol says Sacramento is “overbanked” and expects to see more consolidation in the future as part of the natural cycle within the industry.
As small banks become big banks or merge with major national banks, it creates a ripe environment for the rise of community banks, which can steal market share from the big names on the basis of more direct and personal customer service.
Now that so many community banks have started up, Rossignol and other experts say there isn’t enough of a profit margin to make investors happy. At the same time, incredibly high valuation for banks makes selling them a very attractive prospect for dubious shareholders. Thus, small banks once again become bigger banks and the cycle continues.
Small-business lending tends to decrease in larger bank holding companies, according SBA’s Office of Advocacy. However, when holding companies acquire banks without merging them, small-business lending is only marginally affected.
“In the long term, I think we’ll see that the number of large-cap multiples will increase, small community banks will decline, and you’ll have a meeting in the middle,” Rossignol says.
That can be good news and bad news for business customers. “A business owner can walk into a community bank, sit down with a decision maker and find a tailored solution to meet their needs,” says Dave Alford, principal with Alford-Spencer Financial Group in Sacramento, which monitors the banking industry. “That option may not be there with a bigger bank, but at the same time, community banks just can’t be all things to all people.”
That’s where consolidation can mean good news. It means access to a greater number of affiliated branches and ATMs, along with a wider array of banking services and loan options.
“It also brings more competition to the market in general,” says Janet Lamkin, CEO of the California Bankers Association. “The banks that merge are optimistic about providing more services and being bigger players in the market, while smaller banks see an opportunity to take customers away from the newer, bigger bank.”
If banks are looking at their long-term strategy, customers should be looking at the short-term benefits. The presence of so many community banks means now is a good time for local businesses to look for money.
That’s because banks primarily make money in two ways: by charging fees on deposits and by making loans. The need for deposits notwithstanding, new community banks want to give out money, and local borrowers get to be first in line.
In June 2006, there were 40 financial institutions operating in Sacramento County with 224 offices and deposits totaling $18.75 billion, according to the Federal Deposit Insurance Corporation.
“Because we’re a community bank, the money we take in as deposits gets loaned out right back into the community,” says David Redman, president and CEO with Commerce Bank of Folsom, which opened its doors March 19.
Keeping that money active in the community helps increase what economists refer to as the “velocity of money,” the rate at which money changes hands. When a local bank lends a local business $50,000 to expand, that money is used to pay contractors, hire workers, and pay suppliers. That money is then used again by those people in a variety of ways in the community, from movie tickets to cheeseburgers. Meanwhile, the business that borrowed the money pays back the loan, and those funds are used again for another loan to another business. The money always stays in the community.
In the end, when the velocity of money is high, a relatively small money supply can fund a high level of economic activity to the benefit of the local economy.
“It also helps a local economy when there’s local decision-making ability,” says Cathleen Dougherty, president, Sacramento market with Community Banks of Northern California. “Those local decision makers, who most likely live in that community, have a better understanding of the needs in that community and can put money where it can be most effective.”
Of course, to generate that loan business, community banks have to offer something more than the same interest rate being offered by everyone else. Ask any one of the CEOs at community banks what their niche is, and they’ll say it’s a high level of customer service the national banks can’t touch.
“A typical situation we see is a customer comes in and says they’ve had it with their other bank,” says Mark A. Lund, president and CEO with Community 1st Bank, which opened in Roseville in February 2006. “They’ve banked there for 20 years, then when they needed a small-business loan, they were told to call a loan center in Arizona or something.”
John DiMichele, president and CEO with Community Business Bank in West Sacramento, has had similar experiences and says community banks have an edge.
“A small-business person needs a banker, not just a bank, who has the flexibility to meet their specific needs,” he says. “We’re better able to find customized solutions for our customers.”
Certainly, the majors offer their own advantages — the size of their networks, the diversity of their banking products and their numerous locations among them — but the perception that community banks offer more personal service is not lost on all of them. Wells Fargo, which is in the process of acquiring Placer Sierra in a transaction worth an estimated $645 million, even makes a direct effort to operate in a community bank model.
“We are not one big company, but a federation of hundreds of community banks, each one of which operates to meet the specific needs of the community it serves,” says Felix Fernandez, president of the Northern California region for Wells Fargo Bank. “It’s been a real success story for us.”
Besides the mergers, there’s another factor that makes now a good time to borrow money: Interest rates on long-term loans are relatively low. Intuitively, it makes sense as to why that’s bad news for banks, but the problem is exacerbated by the fact that banks everywhere are facing threats from competitors like financial services provider ING that are offering higher interest rates on deposits. In other words, it’s costing banks as much or more to obtain and use your deposits (short-term money) as they’re earning on the money they’re loaning (long-term money).
“Community banks just can’t be all things to all people.”
— Dave Alford, principal, Alford-Spencer Financial Group
When short-term rates are higher than long-term rates, the result is what’s referred to as an inverted yield curve. Since banks generally fund loans with short-term deposits and make loans on a long-term basis, the inverted yield curve results in a narrowing of the “net interest margin.”
What’s most interesting about the current environment is that the inverted yield curve, which is typically a short-term phenomenon, has persisted for more than a year. “It’s a tough operating environment for all banks,” Lund says. “With persistent pressure on operating margins, we have to focus on controlling overhead expenses and gathering the lowest-cost deposits that we can.”
Large national banks with several profit centers can absorb this squeeze with minimal discomfort, but it can be a real challenge for smaller community banks. “When the margin compresses, banks that rely on high cost funding, such as CDs, get hurt,” says Bob Flautt, president and CEO of Folsom Lake Bank. “A successful community bank will have a higher percentage of its money in core deposit accounts (checking and savings) that have a lower interest rate and makes them less susceptible to a squeeze.”
The good news for business and consumers, of course, is that the current market drives banks to compete, both on the interest they pay for deposits and the interest they demand on loans. It also forces the industry to find new and better ways to make banking more convenient, especially for business customers.
Enter the latest in technology in the form of “remote capture,” wherein a special scanner enables businesses to scan and deposit checks right from their desks instead of having to drive or courier the funds to the bank.
“It’s critical to stay on the cutting edge of technology for customers,” says Debbie Meekins, senior vice president and Northern California executive with Sterling Savings Bank. “In a bank, you simply can’t attract new customers without being on the cutting edge, especially when it comes to business clients.”
One of the other reasons more mergers could be in the works is because selling a bank is so profitable. “We’re in an environment where the median price-to-earnings ratio for banks is 25 times; valuations are at their highest point in 20 years,” Rossignol says. “When you hold that up against a really tough operating environment, it starts looking like a really good time to cash out.”
The exorbitant rise in prices leads some observers to question whether buyers are getting real value out of what they’re paying for, and to suspect outright that some buyers are overpaying.
“Banks have to have a real critical mass in terms of asset size to be profitable,” says Doug Eberhardt, CEO with Elk Grove Commerce Bank, a division of Bank of Stockton. “That critical mass is harder and harder to come by, even with population growth; it takes a lot more deposits, and a lot more effort to get them, to make margins.”
That’s not to suggest the industry is likely to see any rapid deflation in prices. It does, however, put pressure on share prices and fosters the merger attitude: If you can’t beat ’em, join ’em.