Since Jan. 1, 2012, the number of Federal Deposit Insurance Corp. chartered institutions has dropped from 7,083 to 4,672 as of March 31, 2023, a decline of 2,411 charters, or 34% of the banking system.
Of the 2,272 charters that have ceased from the result of mergers or acquisitions, 73 have failed, while only 61 new charters have been issued (not including the two recent charters of Community Unity Bank and Beach Cities Commercial Bank issued in June).
At the current rate of attrition in the banking space, the number of banks operating in the system will be down to approximately 500 in 20 years. Consolidation within the banking system will likely lead to less competition and perhaps certain markets not being served to the degree they are accustomed to.
There are a number of challenges that bankers seeking to form a de novo will need to consider when deciding whether or not to pursue this avenue.
First, de novo institutions take a long time to form and get approval. Executives need to prepare a pre-filing business plan and three-year financial forecast, recruit organizers, directors and executives, conduct market feasibility studies and locate a suitable branch, which can take several quarters to complete and can be costly.
Once the charter application is submitted, data suggests that it still takes nearly a year to open the bank. (The median time was 328 days while the average was 349 days from the time an application was submitted until the charter was issued.) Even once conditional approval is received, the median time frame to open the bank is 104 days. (This data does not include the 14 applications for new banks that are still pending.)
Secondly, the amount of capital required to be raised is high. The median amount of capital raised in successfully started de novo banks since 2017 is $27.3 million. While much of this amount is driven by the business plan and growth prospects of the applying institution, the net capital contributed to the bank needs to be adequate to support the institution during the first three years of operations and a decent amount of capital that is chewed up by startup costs that could be augmented.
Furthermore, applicants can run out of steam during the capital raising process. Already scarce resources dry up, organizers lose interest and are unwilling to contribute more, the project loses momentum and the application is terminated. This is evidenced by the 19 terminated de novo applications since 2018, or nearly a quarter of all applications over that time frame.
Finally, the return profile to investors is not as strong as other investment opportunities. The de novo institution will lose money in its first year or two of operations due to ramping up the banking activities, scaling the balance sheet and generating interest and fee income to cover the costs of running the bank. That deteriorates capital and elongates the investment horizon for shareholders.
In regard to the costs of running a bank, operating expenses are higher now than in past periods due to rising cost of technology, compliance, inflation and personnel to name a few. In many recent de novos, it has been a requirement to have a full-time employee dedicated to compliance despite external options that can be more cost effective.
When public markets are in more bearish conditions, such as those we are experiencing today, investors have numerous options to allocate capital to the financial institutions space in more liquid positions that may also pay a dividend and have stronger access to capital and growth prospects.
So what can be done by regulators to streamline the application process and elicit more de novo institutions? First, they should allow for more flexibility in the business plan and capital structure.
Market dynamics change regularly and sometimes rapidly. One example would be the recent unprecedented pace of interest rate hikes. It is burdensome to the organizers of de novos to have to stick to an original three-year business plan without change despite market conditions shifting.
This also applies to capital. The institution should only be required to maintain well-capitalized guidelines for each year of operations, just as any other regulated institution is required to do. An annual budget is submitted to the primary regulator that should be mutually agreed upon. In structuring it this way, it allows the de novo institution to raise capital as it evolves, and possibly at different valuations, to allow it to continue to attract new investors.
Additionally, allowing for other instruments (preferred equity, subordinated debt or senior debt) to be layered into the capital structure after the initial capital is raised provides an avenue for initial shareholders who took on the startup risk to not be diluted. This also further leverages the existing equity capital, allowing for enhanced returns to those shareholders.
Secondly, regulators should continue to provide proactive communication and support to bankers and entrepreneurs looking to start a de novo. Regulators should be facilitating working relationships with unbiased guidance to allow for a more collaborative process of establishing a business plan that meets the needs of local communities and investors alike, while adhering to the regulatory standards they seek to uphold.
Further supporting the banking advocates at the American Bankers Association and Independent Community Banks of America by providing additional resources is another avenue that could lead to more applications. Both organizations already provide complimentary membership for de novos for the first three years.
Raising the capital required to launch a successful de novo can also be quite burdensome. There are groups in the marketplace that can help to assist organizers with raising the capital. However, the organizers should plan to have a path to raising 70% or more of the capital required within their existing networks.
A recent House bill, Promoting Access to Capital in Underbanked Communities Act of 2023 (H.R.758), is a great example of a business-first, prudent approach to this issue. This bill seeks to reduce certain requirements applicable to new financial institutions, most notably calling on federal banking agencies to issue rules allowing new financial institutions three years to meet capital requirements. Additionally, during the de novo period a financial institution may request to deviate from an approved business plan and the appropriate agency has 30 days to approve or deny the request.
