Nate Mittag and Frank Sorrentino, Managing Directors of FIG at Stephens, joined Brian Love, Head of Banking and Fintech at Travillian, in a conversation about the state of the community banking space in 2023. Economic uncertainties around AOCI, credit and equity have altered some banks’ strategies but Nate and Frank share their thinking on opportunities for banks to plant seeds, think introspectively, and stand out among their peers. The discussion also covers timely topics like M&A, capital raising, share repurchases, tech investments and talent.
How Banks Can Navigate Gray Skies and Seize Opportunity in 2023
1:08 – 6:58 | Navigating Gray Skies
Frank Sorrentino: As we were saying earlier, Nate and I and our whole firm, and I’m sure every firm out there, this is kind of board offsite season. Talking about budgets and strategic plans.
We’ve done a number of these conversations in the last month or so and I’d say everybody sort of agrees that maybe outside of the financial crisis and maybe the beginnings of Covid, this is about as uncertain as an operating environment and as volatile as capital markets that there has been in quite some time.
A lot of uncertainty. We can talk it up to Jamie Diamond saying that there’s a hurricane coming and then maybe not. He walked that back a week ago. But that just tells you how much uncertainty there is out there. There’s no debate on that.
No matter kind of what industry you’re in, whether it’s banks or other companies, it’s going to be a choppy year. As we sit back we are big believers and we really saw this in that sort of 2008-2010 timeframe. Some of the best opportunities, whether organic or M&A came out of significant dislocation and significant volatility.
For companies that are well prepared and that can mean from a capital perspective, a talent perspective, acquisition currency and evaluation, this should be a very interesting opportunity to take advantage of just dislocation. That’s one area we’ve been spending a lot of time on.
We do think that in 2022 there was a pretty significant shift away from growth and technology companies and not just within bank space. I mean, this is more broadly. And this sort of looks like the 2000 era which kind of kicked off a very long time period of outperformance of companies like banks and industrial companies.
Who knew you had to be profitable, right? We’re seeing this story again and I think that the banking industry, generally speaking, is set up very well to come out of whatever we’re going into. And that’s probably a 2024 timeframe. Bank stocks in particular, I think it’s underappreciated, particularly as the larger bank stocks, how much of just cost containment and cost takeout that they have done over a 15 to 20-year time period.
These are very efficient companies, doing great ROEs, great ROAs. So while there might be some credit bumps in the near-term margin volatility, we think from a equity market perspective, in 2024 you could see a lot of money that was previously in growth stocks, tech companies, or FinTech shift into more durable value-driven plays, which banking industry should be a, a great opportunity.
Think about it as almost a renaissance of bank stocks. And then there are some different pieces to that. We kind of call it the blue sky scenario. And we’ve been spending a lot of time talking to folks about what does that mean and if that does happen how do you position yourselves?
Nate Mittag: I think you can kind of see it. One of the things that’s interesting as we kind of started 2023 is we’re kind of actually coming off of a little bit of a rough year in 2022, right? I mean, the bank stocks, depending on what index you’re looking at, are probably down 20-25%.
To Frank’s point, we’ve already started to see the shift within the financial sector. Fintech stocks are probably down, obviously, depending on which Fintech. Challenger bank we’re thinking of are down on average probably 40-45%. And so, you’ve already kind of started to see the shift into your more deposit-taking spread lending type banking institutions.
The reality is, we’ve had a lot of choppiness over the last year. Everyone’s talking about a soft landing, hopefully trying to target a soft landing for those of us that fly a lot, right? Part of it is just we want to land and we want to land intact. We’ve already had a lot of choppiness over the last 12-plus months.
I think Frank is right. The banks are very well positioned in the sense that this is a lot different than 12-plus years ago. Underwriting has changed a lot. Margins right now potentially are peaking going into this first and the reality is, if rates, if we have another 25-bit rate hike and then maybe another 25-bit rate hike, I think banks are at that point where they’re ready for potential rates to hit that plateau and be ready for a higher, for longer environment potentially.
I think in general they’re well prepared on a lot of fronts and the expense point that Frank made as well is a good one. We’re seeing the average bank right now is running in the 50-plus percent efficiency ratio. I mean that’s significantly lower on average than we were in the last crisis.
I think if we do head into a downward economic environment, call it a recession, we might already be in one. The banks are well prepared to come out of it really strong without having really any big blowups.
7:20 – 13:11 | M&A
Brian Love: What is your prognostication for how M&A occurs? Is there a continuation of some mergers equals of bigger shops? Do the credit unions continue to take a little bit more of the banks away?
Frank Sorrentino: I think we’re going to see a continuation of what we saw in 2022.
2022, I think going into the year, everybody was kind of licking their chops. There’s going to be a ton of deals. Valuations are great. Man, that changed fast right in that first quarter, in that February timeframe, Ukraine, Russia, that kind of set everything off and deals have been very choppy since.
It’s not that there’s not going to be M&A deals, but I think you’re going to see a continuation of just lower on average. You probably see less in the way of the large bank M&A because of some of the regulatory considerations. That could change in a year or two, but I don’t think that’s going to change over the next six to 12 months.
One thing you said earlier is very interesting, Brian. So I agree with you that during Covid, a lot of folks looked introspectively and I used to call it, that was the right time to acquire yourself, whether that was buyback zone stock, take out costs, or reorganize. It was the perfect cover.
I think this time though, I think folks are now looking at 2023 and I think maybe it’s because we’re all kind of glass-half-full optimists. There’s going to be some credit issues but people I think, feel generally pretty good about the balance sheet. I think this time we’re actually going to see some, maybe not bigger deals, but I think some transformative M&A deals because I think you’ve got some really good companies who are saying, this is the perfect time to do something transformational.
And there’s no better time when there’s a lot of noise, right? And we are going to be in a lot of noise for the next year. So I think you’re going to see some transactions that surprise people and I have to say, I give a lot of credit to Lakeland Providence. That was a deal. And we can debate what investors liked about it – what investors did not like about it. But the deal does have a lot of strategic merits.
It’s a financially compelling deal and I applaud them for doing that in a very uncertain timeframe. I think we’re going to see more of that. I also think because we’re probably in the later innings of rate rises, there’s a little bit more comfort with the mark to market the tangible book value dilution upfront.
That was probably the primary hindrance of M&A in the last year. It’s going to continue to keep deals slower, but folks are getting more comfortable with it. And quite frankly, I think institutional investors are getting more comfortable. They may not like it, but they are going to get more comfortable with it.
There are going to be more deals with a heavier, tangible book value at dilution. I think we’re going to see more of what we did in 2022, but I think we’re going to see a little bit more in the way of bolder, aggressive M&A deals.
Nate Mittag: I would add to Frank’s point, I mean obviously deposits right now are Cassius King everywhere and folks are thinking about where they are from a capital perspective. Obviously, their tangible book values have been kind of diluted unfairly because of a AOCI.
There’s just been a lot of various things that have affected certain metrics that we, needless to say, are actually very important in M&A. We have a number of clients that are actually trading a pretty healthy premium for their tangible book value.
And they’re saying, look, we want to go and do a deal. But some of their prime targets that have taken big AOCI hits might have low tangible common equity ratios right now. And it’s just hard to make the math work. That’s kind of in real-time causing some headwinds to getting deals done but there’s actually nothing, I think keeping back from a social standpoint, folks from talking. I think we have a lot of clients that are in conversations and it might not be able to get done in the next six months but if you go out another 12 to 18, the market dynamics will change and those deals will get done.
If you go back four plus years ago, when rates were rising, post the Trump bump, and then in 2018 we had rates rising and AOCI actually was a little bit of an issue, not nearly on the scale it is today, but it was something that was being discussed and then people were trying to kind of fair value balance sheets for it.
Once we went the other direction into 2019, because funding had gotten a little bit more difficult the year before. There were a lot of banks that, one year later decided it was time to think about maybe an exit. And so, I think we’ll start to also see potentially some smaller banks thinking about making a transition just because of the funding piece.
In addition to all the other issues that have driven M&A in the past, like succession, things like that.
13:31 – 17:24 | Will Preemptive Capital Raises Be Coming Back This Year?
Nate Mittag: I think a lot of folks probably feel like they don’t need to go raise capital right now. Most folks, I think, are of the expectation AOCI is going to come back, it’s going to enhance their TDC ratio pretty significantly. The reality is, the investors have always focused on tangible common equity and tangible assets.
There could be some banks that if funding costs keep going up as rapidly as they are, I mean, we’re starting to see large banks that have already announced earnings in the 1% plus range for cost of funds. On average, just thinking 30 to 40% betas this year, funding could be an issue.
And I think over time, the funding could be the way for regulators to talk about tangible capital. That could force some folks to think about actually going out and raising equity, assuming the markets are open at that point in time.
Frank Sorrentino: I think at the tail end of last year, started to see it with the FDIC speech and OCC speech, they were sort of on the edge talking about the yes, AOCI is not part of regulatory capital, but it’s a consideration and particularly if interest rates continue to go up or stay high for a long time period.
There are a lot of banks that are pretty stretched on tangible equity and that in itself is not necessarily the problem. The problem is, and to use a recent example, where if you’ve got a sell out of your securities book that’s available for sale and actually turn that unrealized loss into a real loss, it could be problematic.
Now that is an extreme example. It’s very interesting, if you think about the 2008 crisis, we came into that with an inverted curve. A high, high, just high absolute rates. But rates came down and that actually, even though folks had credit issues, you could shrink the company to help absorb some of that.
And you were able to do that because you had rates coming down. So, you had gains on the bond portfolio. Well, this time you have the opposite. You’ve got loan growth that’s still pretty good for a lot of folks. You’ve got funding that is coming out of the banking system and probably is going to continue to come out for some time and you don’t have the flexibility to sell securities at gains.
There could be some situations, I don’t think it’s going to be a ton, but we certainly see situations where banks feel like they’ve got to go bolster just tangible equity. It may not necessarily be driven by regulators. But we always say too, the institutional investors, if you’re a public company, they are a regulator in a different form.
They have a certain threshold that they think you should be at and there are plenty of examples of companies that are trading at very low price-to-earnings multiples. And a big reason for that is because their tangible equity levels are very low, kind of below average. And institutional investors have sort of already given judgment that there is a capital raise coming.
It may not be in your number today, so you’re trading at seven times earnings. But we think it’s really more like nine times earnings because you’re going to have to raise X million at some point. And so that’s got to be factored in if you at all care about at least your short-term valuation, which can impact M&A and just other things.
17:40 – 20:55 | What’s Your Take on Repurchases This Year? Is it a Good Time for it?
Frank Sorrentino: It could be. I guess it depends on how you look at the interest rate environment. I say that because if you think that AOCI is going to come back and it comes back maybe quicker, the life of the portfolio is probably a great time to buy back stock because you could be buying back stock at truly book value in a year from now or at a slight premium.
I always use the Jamie Diamond, Warren Buffet, rule of thumb, probably anytime you can buy your stock back under book and a quarter, it’s a very good idea. It’s a great use of capital. At the same time though, I think for a lot of companies, particularly growth companies. I think you’re probably better off preserving that capital and maybe not doing anything with it right now to kind of grow into, whether it’s your tangible equity ratio, preserve some cash for M&A.
I know it’s kind of crazy to think about it but there is a possibility stocks could sell off again. I mean, look what’s happening with fourth-quarter earnings. The volatility in stocks has been pretty unbelievable. I mean, I’m looking at my screen right now. There are four or five banks, very good banks, who are down five to eight percent right now, daily.
So there might be a better opportunity to buy your stock back. I don’t know that we’re with this bank stock selloff here. And I say that because the fourth quarter earnings have been interesting. I feel like a lot of people knew there was going to be liquidity and deposit outflow issues.
But I think what has caught some folks, some of the investors by surprise, is there’s been a lot more in the way of credit provisioning one-time charge-offs. I feel like everybody thought this was coming maybe in the second or third quarter and so I say that because we might be in the middle of the bank stock cycle. It could be another unfortunately tough year for just bank stocks.
Nate Mittag: I would be happy to echo Frank’s point about. I view it as this feels like a year where you want to salvage some dry powder.
There is going to be dislocation, there are going to be opportunities later in the year. I think retaining capital and cash is important in this market. I think part of where banks are valued right now makes buybacks kind of an interesting debate.
Even if you’re trading seven, or eight times earnings, the reality is if you think there could be some credit issues on the horizon or maybe estimates that are out there haven’t factored in potential net interest margin compression and maybe that’s really like nine times multiple that you’re buying back your stock.
There could be other, better alternatives for saving liquidity to reinvest in loan growth or future M&A.
21:06 – 26:55 | Strategic Opportunities Outside of M&A
Brian Love: Frank, you and I have talked about a lot of the different BaaS banks that we help and getting into something like BasS is a great way to raise low-cost deposits, a great way to create fee revenue payments is another element there. A lot of banks got into digital assets.
Seems like it’s a really muddy road on that side of things right now. How are you advising and what are boardrooms talking about in terms of new areas to get into?
Frank Sorrentino: A year ago, if you would’ve asked me that, it was all about understanding digital assets, banking-as-a-service, how do we play, can we play?
What does it take? Who’s the competition set? I feel like and I don’t know if it’s just because of the companies that we’re focused on, that has gone 180. I think folks, it is a pendulum, always swings too far, right? We might be in, the pendulum was too far last year and everybody looking at it now, we might be in the opposite where not enough people are going to be looking at it because there are some really, really good stories there.
I mean, I think about banks like MVB, Coastal, they have done a very nice job and I think have built very valuable franchises and knock on wood, continue to. So, I actually think this is a great time to be looking at something like that. It’s probably easier, there’s less competition than there was a year ago.
There’s that side of it. The other thing that’s been coming up a lot with boards is this deposit environment and just interest rate environment I think has a renewed focus that core deposits are the most important thing. And whether that means maybe it’s not doing a new branch, but maybe it’s, hey, go spend some money on hiring out a treasury-focused commercial team.
We’ve had a lot of conversations with clients around that. I think, especially during the Covid era. A huge shift to, let’s cut branches out. We’re having clients today that are asking us about branch acquisitions.
It’s just a 180. Maybe going back now that the sort of trends that were very powerful at the beginning of Covid. Some of that has subsided. Now we’re in a little bit of a world that’s got a combination of Covid trends and then sort of pre-covid trends, finding that right balance. Maybe you do need to open another branch office or you have to reposition branches or lift some branches from somebody else.
I think we’re early in that process, but a lot of boards are now asking how do we gather for deposits. And I think coming back to M7A, that’s probably the fastest way to do it and could be the most efficient way.
Nate Mittag: A couple years ago, I mean, literally maybe 16 months ago, everybody was talking about lift-outs of commercial lenders, finding good lending teams. There had been a lot of M&A obviously over the last few years, so there was potential dislocation around talent out there.
Obviously, with Covid, talent was really, really hard to come by. It was all about finding lift-outs on the earning asset side. Now, obviously, everybody’s looking for funding and so they’re kind of like thinking about the old-school methods. Like Frank said, should I just go buy branches? You need capital to buy branches, by the way, and you need cash.
Because you have to pay premiums and obviously deposits are worth a lot right now. And so I think one of the things to tie it into the original part of the question, which you know, was other ways to kind of invest outside of M&A and you mentioned BasS and Fintech and Frank mentioned MVB and Coastal.
The interesting thing is that I think a lot of banks’ management teams have been thinking about ways to creatively enter the digital world and they haven’t been quite sure how to figure it out. Particularly smaller community banks that might be scared to spend on the infrastructure. You know, MVB is a great example in the sense of what they did was they found a niche, they found something that they wanted to focus on and build, and it happened to be on the liability on the deposit taking side.
They’ve transformed their balance sheet in a sense where I think 50% of their deposits now are non-interest-bearing checking accounts. I mean, technically checking non-interest-bearing deposits. So, that’s a transformation where they use technology and Fintech and banking-as-a-service really to a solid advantage to achieve a goal.
And I think that’s going to be, banks that maybe haven’t dove in yet to Fintech, can try to figure out a way to take advantage of it, is you have to find some way to differentiate over time. All these banks are going to have a digital part of their franchise. It’s just part of the future.
It’s just part of the transformation of the business over time. We’ve had a shrinking number of banks every year and over time the banks are going to get better at digital. But I think, trying to find something to be good at in a niche is kind of a way to differentiate and use it to help business.
27:33 – 29:58 | New Asset Classes, Products or Services that Banks are Getting Into
Frank Sorrentino: No, almost the opposite. I think we’ve seen and probably chalk this up to all the excess liquidity that entered the system in early 2020. A lot of that was deployed into whether it was bond portfolios, but also things that are more wholesale on the loan side, like consumer lending pools that were basically fintech originated that were bought and I feel like not all of it but a lot of that is getting run down, not taken up again.
And so I think a lot of banks are getting much more core on the asset side because they do have funding challenges. I think you’re going to see loan-to-deposit ratios are just continuing to climb. We’ve heard some pretty extreme examples of banks going from the 80% area who are approaching the hundred percent area pretty quickly.
I think it’s actually going to be more of an everybody’s sort of letting non-relationship, non-wholesale stuff go to the extent that they can and getting more down to a core franchise.
It’s funny, I was thinking back to our conversation that we had in, I think it was August of 2020. I was not in my office. I don’t think anybody was in an office at that time. And remember talking about deposits and at that time, nobody needed them. And we were talking about that’s the best time to buy when nobody needs them.
That’s probably when you’re going to get them the cheapest. I think about the environment for anybody that wants a mortgage banking business, this is the time to buy it. You’re probably not going to get it any cheaper. And I’d say the same thing maybe for certain lending categories, whether you’re listing out a team or do you find the right specialty finance company.
I have to think that if you’re in the sell mode today. You don’t want to be selling unless you have to for a succession or liquidity. But if you are, it’s a buyer’s market for certain assets like that. And so this is the exact right time to be thinking of something like that.
30:04 – 34:45 | Talent
Nate Mittag: Frank’s absolutely right. I think it’s a buyer’s market for talent too. You have a lot of folks out there that are thinking about downsizing and they’re cutting costs, they’re cutting expenses, and there could very well be, like I mentioned earlier, 12-plus months ago, we were in an environment where everybody was really looking for talent, trying to buy talent.
It was really hard to find it at a relatively, call it reasonable cost. But I think the market, we’ve seen it even change within our investment banking world, right? It’s becoming a little bit of a different market than it was just post Covid. To go out and find talent that could be a little bit more affordable, but could be very helpful to the franchise.
Brian Love: We’ve actually seen some of the banner placements we’ve made have kind of supported your thesis. They are Fintech Presidents, Head of Digital Banking folks that are going to lead the bank into new asset classes, new types of generations, embracing technology and then using it across the bank.
And then you’re also seeing the advent of Chief Strategy Officer roles. It’s not new but I’d say 10 years ago, you didn’t see that CSO title that often. We’re seeing more searches kind of like that, where there’s a great executive team but it’s missing apart. It’s missing someone who has that wherewithal who knows how to go out and buy that company, get that team, deliver it and integrate it.
That’s not a talent you see on every single executive team, especially when you go a little smaller in the community bank sector.
Frank Sorrentino: Nate and I have said this many times and very pertinent for analyzing M&A, at the end of the day, unless you’re buying a company that’s got a very niche business model, a lot of community banking is commoditized, you are buying talent, and you got to always be thinking about talent, whether it’s lifting out from organically, hiring within, or M&A, it’s the most important piece. And it is very interesting. I think this has always been true, right? Banks are usually sold, not bought.
And that really gets to management and succession. And we’re seeing in a lot of geographies that right now, for many factors, there’s probably more willing sellers at reasonable valuations than there are acquirers who can and will do M&A and that’s going to continue and it’s because of a lot of the CEO ages.
That probably drives more strategic deals, mergers of equal type deals. And that is even more important when you think about talent and how do you assess a combined company. Because those are just trickier deals but Nate and I have been spending much more time on anything talent related because as branch counts shrink and it’s more technology, talent becomes that much more important for just execution.
Nate Mittag: I agree. It always feels great when you work on a transaction where the management team of the acquiring is actually taking on some senior-level folks on the management team of the selling bank. It just makes everybody a little bit more warm and fuzzy, a little bit more comfortable with both they’re taking on. Everybody’s going to still have a stake in it.
I worked on a transaction earlier this year where the selling company was a much smaller bank, but their CFO is going to be the Pro Forma CFO of the whole company going forward. And the buyer is very, very excited about that. It takes a load off certain folks’ shoulders.
It allows other folks to focus on strategy. I think it helps particularly banks that are focused on doing M&A, be able to kind of, when they have somebody that’s really focused on strategy or M&A is a business line, et cetera, it just helps the whole management team be able to prioritize individually and I think that’s better for the company.