Tuesday, March 23, 2021

Fintech Buys Bank. Keeps Stratospheric Valuation.

Imagine a fintech, with off-the-chart valuations such as 2.6x book value and 51x EBITDA, buying a bank. For 1.85x book. 

In today's M&A valuations, 1.85x is pretty lofty. Especially for a community bank. But you don't have to imagine it. Because that was what LendingClub paid for Radius Bank. Since the deal closed, LendingClub has kept its valuations. In fact, since February 17, 2020, one day prior to the Radius Bank deal announcement, LC's share price has risen 58% versus the S&P BMI Software & Services Index increase of 20% (see chart). 

LendingClub bought a bank and didn't trade down to traditional bank valuations. Their valuation grew loftier. Making for even better currency to buy even more banks. And putting them at a strategic advantage over other would-be financial institution buyers mired in the lowly yet more rational bank stock valuations. Truth be told, LC paid mostly cash in the deal. What's cash worth these days? And there are plenty of examples of investors throwing barrelfuls of cash to technology firms.

This is a clear threat to financial institutions. How can we overcome such a hurdle? I wrote that one primary reason banks need scale is to enjoy greater trading multiples. It was one of my most read posts and is a chapter in my upcoming book, Squared Away (soon to be available in your favorite bookstore). 

But we can't pay 2x book for a target when our stock is trading at 1.2x book. Even if we enjoy higher bank-like trading multiples because of scale we may get to 1.5x. Green Dot Corporation is currently trading at 2.6x book and over 6x tangible book. They can easily afford 2x book with that valuation. With more experience acquiring banks in the rearview mirror, fintech's who might have once been worried about bank valuations weighing them down, will be more confident to bid on for-sale banks, to be aggressive, to get deals done. 

Having said that, net interest income is a very small part of  LendingClub's revenue mix, at 22% for 2020, which was prior to the close of the Radius Bank transaction. And they're in the business of lending! Green Dot Corporation showed less than 2% revenue attributed to net interest income. So the continued lofty valuation might be relating to the relative size of the bank within the fintech. 

We were worried that credit unions would be buying banks. Using their ample cash positions, which aren't earning much in the investment portfolio or at other financial institutions, and turning taxable earnings from target banks into non-taxable earnings at credit unions.

What about fintechs that may not be too concerned about profit? I reviewed LendingClub's last five years and see nothing but red ink. Radius Bank had net income of $6.7 million in 2020. On a consolidated basis with the currently bleeding LendingClub, that might revert to tax-free money. Just what we feared with credit unions. 

Should we be worried about more fintechs stepping up to buy banks? (Ref: SoFi and Golden Pacific Bancorp) 

Will these precedents be part of a trend?

~ Jeff

Friday, March 05, 2021

CFPB: Are They Coming to Get You?

A bank trade association CEO asked me a couple of questions while he was researching an op-ed piece. The edited Q&A is below.

Q. Shouldn't the CFPB work to address the impediments to starting a bank in LMI markets rather than punish community banks who scrambled to serve their customers when the economy shut down?

Author's note: This was probably relating to the late January released statement about the acting director of the CFPB's promise to take aggressive action in response to perceived Covid-19 relief violations, including the policy of some banks to only take PPP applications from pre-existing customers, which may have a disproportionate negative impact on minority-owned businesses.


A. The problem stems from the spreadsheet, in my opinion. With deposit spreads so low, branch deposit sizes need to be very large for a branch to be profitable. According to my firm's profitability peer group, a branch with $74 million in average deposits made a mere pre-tax profit of three basis points. That is a fully absorbed number, with support center expenses allocated to it. On a direct cost basis, the branch must be at least $38 million in deposits. Knowing this, very large financial institutions operate branches where they can have greater scale to drive greater profitability, which frequently excludes LMI neighborhoods, creating what is termed "bank deserts."

Another challenge is imposed by the very government that tries to assist LMI households: regulation. The average operating cost to originate and maintain an unsecured personal loan is $287 (again, according to my firm's profitability outsourcing service peer group). And the average balance per account is $3,800. The spread needed to cover the cost alone would be 7.5%. That's not the yield... it's the spread. So if the bank's cost of funds was 1% the yield would have to be 8.5%.

But there's more! The provision for loan loss is 1.25% of that balance. A bank would have to charge a 9.75% yield on an unsecured personal loan just to break even. The operating cost is largely attributable to the distribution through the branch network and regulation. Since a bank can't cut regulation, they trim their branch network to lower those costs. And the obvious bullseyes are on branches that lose money.

Similarly, the annual operating cost per account for a retail checking account is $398. With a 1.89% spread and with 0.91% average fees as a percent of balances, the average balance of a retail checking account would have to be over $14,000 to be profitable. A very high hurdle in an LMI neighborhood. Again, much of the cost per account is driven by branch distribution and regulation. Retail banking is heavily regulated. And it's difficult for financial institutions to operate in neighborhoods that have low average balance loans and deposits. Plus, if an institution charges the high yields on loans to be profitable, or assess the high fees it would need to make the retail checking account profitable, think of the reputation risk they would assume. That is why very few of our clients consider retail banking as the driver of future profitability in strategy sessions. 

Q. Should communities today be concerned by the M&A activity taking place? What advantages or disadvantages do they face when institutions consolidate?

A. If we lose 4% of FDIC-insured institutions per year, which was pre-pandemic pace, we will have ~ 3,300 institutions in 10 years. There are people that believe we are over banked, and look to Canada and Europe as case studies for having fewer, larger banks. There are benefits to scale. The most efficient banks in the U.S. tend to be between $5 billion - $10 billion in total assets.

But there are myriads of examples of very efficient $500 million banks, and technology should make it easier for smaller community banks to deliver relevance-sustaining profitability that enables the bank to invest in its future by remaining relevant to its stakeholders. The really small institutions, however, should consider merging, even if one or two engage in a merger of equals to have the resources to remain relevant. Smaller institutions run the risk of nobody wanting to buy them.

As institutions get larger, and their HQ's get farther away, decisions are made that can be sub optimal to the local area, town, and/or borrower. For example, think of the Credit Analyst in Charlotte evaluating a rural Indiana ag loan to an Amish borrower. What does that write-up look like? We will lose that local flavor to allocating capital by centralizing banking. That is what I fear we will lose by continuing the trend that took us from 15,000 banks in 1990 to less than 5,000 today.

~ Jeff