Are Smaller Banks a Good Investment?

The general picture I have been drawing of the banking industry is as follows: big banks are doing well; banks that are not big are not doing so well.

Who do I consider to be the big banks?

The big banks are the largest twenty-five domestically chartered banks in the United States and these banks hold two-thirds of the banking assets in the country. These banks, as a group, are doing very well.

The not-big banks are all the rest, some 8,000 domestically chartered banks that hold approximately one-third of the banking assets in the United States. These banks are not doing so well.

The evidence of the condition of these not-big banks is that the Federal Reserve is keeping its target rate of interest at 25 basis points or below and has pumped around $1.0 trillion in excess reserves into the banking system. The FDIC has approximately one out of every eight banks in the country on its problem bank list and is closing three to four banks, on average, every week. It is expected to continue at this pace for another 12 months or so.

Commercial banks are not making loans and this is true of the not-big banks as well as the big banks. In the not-big banks the problem seems to be dealing with the bad assets they have on their balance sheets rather than just an absence of potential borrowers.

Yet, within this environment, we hear and read about people, funds, or groups buying up the smaller banks and attempting to consolidate them into viable and vibrant regional banks…and possibly more. The New York Times on July 8ran an article on just this type of activity: “Financier Invests in a New Jersey Bank”, http://www.nytimes.com/2010/07/08/business/08bank.html?_r=1&ref=todayspaper.

Does this make sense?

My answer to this is “Yes, it does make a lot of sense!”

The New York Times article is about Wilbur L. Ross, Jr. who is expected to announce the purchase of a stake in the New Jersey banking company Sun Bancorp, an organization that has around $3.5 billion in assets.

Mr. Ross, according to the article, has predicted that “hundreds of the nation’s troubled banks will fail” and that there will be a substantial consolidation of the banking industry over the next few years. In earlier posts, I have also argued that the banking system, now at 8,000 banks, will consolidate, dropping to a total of no more than 5,000 banks in the next five years, maybe even a lot fewer.

Ross, who has already acquired banks in Florida and Michigan, stated that this acquisition could be the first of many he acquires in New Jersey.

“The next 18 banks in size (in New Jersey) after this one (Sun), together, have around $5 billion in deposits, and there’s another 100-some-odd banks that, in total have $40 billion in deposits.” Ross argues that “That’s just way too many banks for one state to have.”

The financial industry is changing. The largest twenty-five commercial banks in the country are going to be one thing. I believe that these banks will move from about two-thirds of the banking assets in the country to about three-fourths. They will be an entirely different animal of their own making. I have written many posts on what these banks might become in the Information Age.

The other one-fourth of the banking assets in the country will be in banks that are larger than the average not-big banks that now exist, but will be more “client-first” banks, banks that are more relationship based like the outstanding banks we knew in the past.

Certainly, these banks will change because they, too, are a part of the Information Age. However, they will not be the diversified financial giants inhabiting the territory of the largest twenty five big banks. But, this change to incorporate the technology of the Information Age will alter these smaller banks in a fundament, yet different way. More on these changes in future posts.

Aside: It is interesting that a new biography is just currently hitting the book stores, one that deals with an “old fashioned” banker who emphasized, successfully, doing business in the traditional way. See “High Financier” The Lives and Time of Siegmund Warburg” by Niall Ferguson. Yes, this is the Niall Ferguson that wrote “The Ascent of Money.”

I believe that there exists a tremendous opportunity in the restructuring that is currently taking place in the banking industry. Of course, one must not rush into these “deals” hastily for there are many problems that still exist within the industry. Remember, that is a major reason that the Federal Reserve is keeping interest rates so low. Also, there is the change in financial regulations that are currently being written in Washington, D. C.

Still, there is a major restructuring taking place in the banking industry and when such a restructuring takes place in an industry, opportunities abound. This is a chance to get in on the ground level with the “new” relations-based commercial banking platform. It is a chance to be a part of the new “Information Age” banking organization. And, to me, this restructuring is going to take place through the consolidation of existing banks so as to achieve the appropriate scale and geographic distribution of offices.

The consolidation of banks will not be achieved over night because of the time and energy it takes to put organizations together. Furthermore, many of the consolidating banks will have problems, these banking assets must be “turned around” as well as combined and this will take time and energy. But, it can be done.

Furthermore, these banks need to be “conservatively” run. That is, in my mind, the new banking rules and regulations will not be an impediment to success. I have been a part of three “turnarounds” myself, two as a CEO and one as a CFO, and have raised millions in capital. I always wanted these banks to have policies and procedures that were stricter than those imposed by the bank regulators because I did not want regulators to have a say in the decisions of the bank. Even within this “conservative” requirement, the banks were “turned around” and achieved attractive returns. This can also be achieved within the current environment.

Smaller banks can be a good investment and an organization intent upon building a 21st century, client-based commercial bank through the consolidation of these smaller banks, I believe, can be quite successful. This is certainly an area to keep an eye on.

Disclosure: I am now a board member of a startup organization, e3bank, attempting to build a 21st century, client-based bank. More information can be found on this bank at http://www.e3bank.com/.