Build or Buy 2.0: The Best Way to Start a Bank Post-COVID

Conditions have certainly changed since we last evaluated the choice between starting a “new” bank with a de novo charter versus purchasing an existing bank to implement the “new” bank’s business plan. When we wrote our first Build or Buy article in the fall of 2019, the economy was still riding a steady ten-year expansion and the potential for new banks looked generally positive. In addition, unlike most periods of time in the past, there were fairly evenly matched pros and cons to both routes for starting a bank.

Starting a de novo bank still has benefits in that founders can begin with a clean slate and can save both time and money that might otherwise be spent looking into which bank to purchase. Further, current regulatory policy has loosened requirements in an attempt to support new bank formation. However, downsides include significantly higher capital raising requirements, comparable investment returns available from more established bank stocks, and bank regulators’ reluctance to approve innovative or high-growth business plans.

Conversely, buying an existing bank and operating as a de facto de novo has the benefits of avoiding startup costs by utilizing existing systems while also taking advantage of potential existing profitability that may be leveraged. Existing banks further offer substantially more flexibility in developing the bank’s business plan and structuring compensation for bank organizers. Potential difficulties lay in finding a suitable acquisition target, continuing to serve the bank’s existing market area if the new growth is focused elsewhere, a less clear regulatory pathway, and possible costs associated with replacing legacy infrastructure and IT systems.

Unfortunately, 2020 brought the onset of the COVID-19 pandemic and with it came economic downturn and stock market upheaval. Banks were particularly negatively affected. Moreover, as the overall stock market has rebounded over the past months, banks were more sluggish in their recovery. The KBW Bank Index, a weighted average used to track national and large regional banks through 24 stocks, recovered most of its loss by January 2021 from a near record highs in January 2020. Meanwhile, over the same time frame, the NASDAQ Composite has bounced back to reach record highs.

Though turbulent banking conditions have shifted expectations, some timeless considerations remain relevant in deciding between a de novo bank or purchased bank. However, these current economic conditions have also created fresh considerations for bank formations. Today, a group seeking a bank purchase or de novo charter must navigate:

• Tough capital markets for thinly-traded bank common stock
• Concerns over deteriorating credit quality
• Expected continued low interest rates that constrain bank profitability
• Increased bank regulatory stipulations for excess capital requirements due to fear of deteriorating credit quality
• Rising bank management fatigue due to maneuvering tough economic conditions
• Growing popularity and necessity of remote and online delivery methods that minimize the need for branches
• Fintech competition becoming greater as nonbank alternatives become more accepted and fintechs become more bank-like.[1]

Separate from these changes caused by the post-COVID economic dip, financial regulators have acted somewhat leniently — signaling an easing of certain banking activity restrictions. Financial regulators have continued to state that they support the creation of new banks. For example, in an interview on June 25, 2020, OCC Acting Comptroller Brian Brooks laid the framework for payment companies to increase their scope through a federal payments charter.[2] This would ease access to nationwide markets and set payment companies on the path to eventual access to the Federal Reserve. While this is a positive development in that regulatory hurdles have been lowered, new banks will view this negatively as the door has been widened to permit more competition between financial institutions and fintech companies. As of the early-January date of this article, it is still too early to tell whether the November 2020 election victories President Elect Biden and Senate Democrats will signal a shift back towards increasing regulatory restrictions.

Organizer groups looking to build a new bank may view these constraining factors and regulatory updates differently, depending on the group’s strategy, location, and experience. De novo banks face decreased interest rates creating diminished margins of return, an especially troubling experience for a brand-new bank trying to get its legs underneath itself. Further, already high requirements for excess capital are likely to be further increased in an attempt to avoid the bank failures that were so prevalent in the 2008 financial crisis. Thus, de novo charters may prove challenging even though regulators have expressed supporting them at higher levels.

Purchased banks face slightly different difficulties in the current economic climate. The combined fears of high credit costs and significant loan interest deferrals makes buying a small bank much more challenging than in a more benign credit market. However, the high rates of management burnout caused by the rigors of navigating a more constricted financial economy means that there are likely deals available with prices at or below book value.

In sum, there are certainly new and exacerbated challenges caused by the COVID crisis. However, potential management burnout and struggles in other banks may mean that there are value acquisitions to be made and market niches to be filled. Though there may be heightened burden to entry, all is certainly not doom and gloom in the post-COVID banking world. We still expect new banks to form, though they will likely take longer to raise their initial capital and occur with less frequency than we thought at this point last year. These current market conditions also mean that it remains prudent to explore both a de novo charter and bank purchase options. At least one recent analysis of the industry had already been leaning towards an acquisition approach before the recent market dip.[3] Following COVID, the scales seem to have been tipped even more towards “buy it” versus “build it” due to lower potential valuations and management fatigues in the current market.