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Legislation will drive small banks out of business E-mail

Veteran analyst condemns Dodd-Frank hit on small banks



By Richard Bove, vice-president, Equity Research, Financial Sector, at Rochdale Research, Rochdale Securities, LLC. Stamford, Conn., www.rochdalesecurities.com. This guest column is reprinted from Bove’s client letter. It originally ran under the title, “Wave of Acquisitions: Legislation Will Drive Small Banks Out of Business.”

Cross Purposes
I have repeatedly argued that the new banking bill was created by a group of hysterics who know little or nothing about banking. Another example of this “fact” is the contradictory themes in the legislation related to small banks. If the regulators do what Congress has mandated, the new law will drive these companies to sell their businesses or simply fail. It is creating a significant opportunity for bank acquirers to buy small banks at distressed prices; accretive deals.

Desired Results
Congress wants the following:

1. Big banks to shrink.

2. Small banks to take over a larger responsibility of lending to the economy.

Banks to increase their capital.

4. Banks to increase their liquidity.

5. The Fed to orchestrate stress tests every year and those stress tests to touch all banks over $50 billion in size.

6. Trust preferred securities to be eliminated from the banking system.

7. To create a new program making $30 billion available to small banks to lend to small businesses.

Inherent Conflicts
This is what the hysterics did not think about when they were writing their law.

1. By eliminating Trust Preferreds as a source of capital, not only did the Congress remove the primary source of funding for small banks but it increased the need of these banks to raise capital from other sources as the existing Trust Preferreds mature.

2. When the smaller banks are stress tested on an annual basis, as is now the law, the likelihood is high that the test will have very stringent requirements concerning commercial real estate. This will hit the smaller banks hard since they tend to be relatively larger lenders to this part of the economy than to, say, consumers or businesses.

3. Thus, the stress testing will reveal a need for additional capital.

4. Further, it appears that the new capital rules, to be unveiled in November, will require higher capital ratios under the Tier 1 system.

5. Net result small banks will be required to develop more capital without being able to use their preferred method for raising funds.

The small banks will not get the money they need. If I am wrong and they do get the money it will dilute the ownership position of the current holders of the stocks. These owners are far more likely to want to sell their stock than sit back and be diluted.

They will sell these banks. With many banks seeking to sell at the same time, a buyers’ market will develop. The big banks will get accretive deals and they will get bigger. The small banks will continue to fade away. Thus, the law has within it the seeds to make it impossible to meet the goal of shrinking the big banks and stimulating the small banks. What is most surprising is that the small banks supported this legislation.

Question 1:
A $30 billion lending program requires bank capital to support it. Where is that capital going to come from?

Question 2: How long is going to take the hysterics to repeal this law?

[This article was posted on July 30, 2010, on the website of ABA Banking Journal, www.ababj.com, and is copyright 2010 by the American Bankers Association.]

Comments (1)add comment

Claude Hanley said:

I agree with you that smaller banks will be forced to raise capital and that the unintended consequence will likely be that many small banks will sell or merge. The IMF report released on July 30, 2010 will add momentum to this push among policymakers to increase capital. The report estimated that small and regional banks would need $40.5 - $76.3 billion in additional capital. In my opinion, that level of capital cannot be raised unless investors believe that they will receive a high return on their investment from the sale of the bank. One point of clarification: my understanding is that the requirement of an annual stress test applies only to financial institutions with more than $10.0 billion in total assets. Regardless, the dynamics you describe will still apply to those institutions that aren?t subject to an explicit stress test.
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