Capital Raising in the Middle Market:
Basel III Will Hurt

dinosaur skeleton with monacle

Community banks as we know them may become extinct if they don’t evolve.

 

An article in the American Banker which stated, “Community Banks: Basel III Will Put Us Out of Business”, is not news, at least not for those that follow our thinking.  The community banks are being treated just like any other bank, and that’s not just because of Basel III.

 

The truth as we know it is that the Fed wants fewer banks.  We still have something like 6-7,000 banks nationwide.  Canada has six or seven, and even adjusting for the difference in the size of the economies, we need about 100 at most.  We have a long way to go.

 

Banks with assets of about $10 billion are as efficient as they can get, at least according to the statistics we have seen.   Moreover, they are still small enough that they don’t present systematic risk.  And importantly, they have sufficient scale to have in place the tools that the Fed really wants them to have.

 

Since the the end of 2009, the number of banks in the U.S. has decreased by 15% compared to 20% in the 1980-1989, 36% in the 1990-1999, and 22% between 2000-2009. Data on average assets per employee tells a similar story of disparate scales. Since January 2010, the bigger banks have nearly twice (87%) the assets per employee than the 4,090 community banks with assets between $100 million and $1 billion. The gap between bigger banks and the 2,056 banks with under $100 million in assets is more than double (119%). The trends suggest that these disparities will keep getting bigger.

 

The Fed wants to sit and look at its dashboard and understand the health of the economy.  They also want to be able to see in near real-time the effects that any particular event or decision will have on it.  It doesn’t want any surprises, and that means no exceptions.  They want the same loan being credit scored the same way with the same amount of capital reserved against it regardless of what bank it is housed in.    That is not the least bit unreasonable.

 

Importantly, the Fed can’t have a real-time dashboard if community banks are still using Excel.  The Fed wants the enterprise risk systems of all banks to download into theirs.  That means survivors need sophisticated systems, and sophisticated systems require scale.

 

The consequence is that capital raising for middle market and lower middle market companies being funded by community banks could be in for a nasty surprise.  Credit availability could evaporate for some banks, and their borrowers.  Companies that are at risk of financial distress will find themselves looking for a new (likely non-bank) financing source.  If they don’t, they may find themselves an involuntary sell side M&A candidate.  That happened a lot during the financial crisis.

 

The way bank assets are rated will put term loans into a very expensive category.  The longer the term, the greater the capital that must be reserved.  Short term loans will the only thing that many capital-short banks will be able to offer, such as one year, or 364 day revolving lines of credit. With all their debt due within on year, that leaves companies vulnerable to liquidity risk.

 

Our advice to lower middle market and middle market companies is to understand the credit strength of their bank.  If you aren’t sure how strong is strong, please don’t hesitate to contact us. To learn more, contact us



by Charles Smith

Mr. Smith is the founder of Pegasus Intellectual Capital Solutions, a boutique investment bank specializing in mergers and acquisitions, Capital Raising and restructuring and workouts. The firm is an innovator in the use of Intellectual Capital Audit for pre-closing due diligence and in turnarounds. Charles can be reached at csmith@pegasusics.com