This is the third installment of our series¹ evaluating the choice between starting a “new” bank through the de novo chartering process or purchasing an existing bank to implement the new business plan. Since we first wrote on this topic, we have been fortunate to assist a number of clients in forming both de novo² and de facto de novo banks, including even during the turbulent financial markets in 2023.³ The recent economic downtown, partially caused by the Federal Reserve’s efforts to combat inflation, has noticeably slowed de novo bank organizational efforts. The depressed stock prices for banks and the high-profile failures of several banks in 2023⁴ have also curtailed the interest of both prospective organizers and investors in pursuing new banks. In addition, in our experience, the supportive attitude of the FDIC to de novo banks under former Chairwoman Jelena McWilliams has been supplanted by a less favorable attitude and more prolonged reviews from the agency under current Chairman Martin Gruenberg. Nevertheless, we believe there continue to be significant opportunities to pursue, particularly with de facto de novo banks, as banks acquired in challenging environments can present huge opportunities to investors or acquirers.

Other regulators have also noted the shift in the FDIC’s attitude toward de novo banks. Federal Reserve Gov. Michelle Bowman, speaking at the Wharton Financial Regulation Conference in April, stated that the onerous process of getting a new charter is hurting competition in banking. She called for bank regulators to take a new approach to de novo banks to make the chartering process more streamlined and transparent. She noted the growing instance of companies seeking to purchase banks just for their charters and then implementing entirely new business models, which she referred to as “charter strips.” She argued that the fact that these “charter strip” businesses are growing while the number of banks shrinks is an indication that there is “dysfunction” in the regulatory regime around new charters. In a well-functioning system, she believes, new entrants should value a purchased charter and de novo charter equally, or might prefer the "clean slate" of a new bank.⁵ Indeed, we concluded our last installment of this series in January 2021 by stating “the scales seem to have been tipped even more towards ‘buy it’ versus ‘build it’ due to lower potential valuations and management fatigues in the current market.”

Although somewhat removed from the instant decision of whether to build or buy, the depressed stock pricing for publicly held institutions (and related reduction in M&A activity and pricing) both reduces one of the perceived upsides of starting a new bank and reduces the downsides of seeking to acquire a bank. Depressed market prices reduce the ability (and interest) of larger potential serial acquirers, thereby contributing uncertainty and a reduction in the potential exit multiple that may stimulate investment in de novo banks. Conversely, the reduced potential competition from banks looking for acquisitions and lower M&A pricing improves the ability to find a bank to acquire at a price that is attractive to all parties (assuming the target bank does not have excessive unrealized loan or investment portfolio losses).

What we see today is a heightened interest by small, typically rural banks to sell due to management burnout (caused by the rigors of navigating a more volatile financial environment) and challenging stockholder and board succession issues. In addition, potential seller banks are growing more fearful of higher credit costs due to a riskier credit market, and many have experienced greater increases in deposit costs than in loan revenues, cutting their bank’s profitability. This decreased profitability and other factors (e.g., depressed bank stock prices for banks as well as bank failures mentioned above) have resulted in pricing for some regional and community banks at or below book value. Generally this should spur investor interest, given that de novo banks, upon opening, inherently trade at a premium to book value given the costs to open. Still, the greatest challenge to the “buy it” approach remains finding and negotiating with a suitable acquisition target. Also, while competition from Fintechs seeking to acquire a bank charter has slowed (perhaps contributing to lower pricing), Fintechs and other nonbank alternatives continue to become more accepted by customers and remain tough competitors for small banks.

With respect to starting a de novo bank, organizers have traditionally believed that they could save both time and money that might otherwise be spent looking for and negotiating with a bank to purchase. However, the regulatory approval slowdown and investor concerns (especially given comparable investment returns available from more established bank stocks) have resulted in longer de novo periods and increased startup, or pre-opening, costs for organizers. Furthermore, regulations applicable to de novo banks, including limits related to founder equity, are generally more stringent and onerous than those applicable to purchasing an existing bank. Absent underlying asset value concerns, an acquisition can save time, result in fewer limitations on the bank’s growth, and offer the benefit of a ready-made core banking system and existing customer base.

While bank acquisitions have been scarce this year, with only 54 closing as of the end of August 2023, nonbank investors have made up an outsize share of the market, with five completed deals, according to S&P Global Market Intelligence. On the other hand, only four de novo banks have opened thus far in 2023, each of which submitted their initial regulatory applications more than a year prior to opening.⁶

However, groups searching for a bank to buy need to be mindful of the risks of surprising the bank’s regulators with material changes to the bank’s business plan. Fed Gov. Michelle Bowman gave the term charter strip a pejorative connotation, but there is nothing inappropriate with acquiring an existing bank and changing its business model – following discussions with the bank’s regulators and obtaining approval or nonobjection when required. 

The acquisition of Farmington State Bank by crypto-focused investors in 2020 serves as the poster child for an improper charter-stripping transaction. The regulatory approvals for the investor group to acquire Farmington State Bank were similar to those imposed on a de novo bank, including that, for a period of three years, all changes in senior management, material changes to the business plan, and any significant changes in operations would require prior written regulatory approval, including providing updated business plans with three years pro-forma financial statements for any new strategic initiatives or significant operational changes. 

Yet the bank flouted these commitments, and within a year of the acquisition management was engaged in a wholesale repositioning of the bank as a service provider to “fast-growing innovative and disruptive sectors.” This included a business agreement to design and issue stablecoins, despite an explicit ban on such activity in the acquisition approval. This, it should go without saying, is something a bank should never do. As one former regulatory attorney commented, “such blatant disregard of approval conditions” by the investor group “is unprecedented and really quite astonishing.”⁷

Even when a bank is not planning changes to its business model that would require prior regulatory approval, we always encourage our clients to meet with their regulators in advance of pursuing changes to the bank’s business model and, at a minimum, obtaining an informal non-objection. Otherwise, there will be a significant risk that the regulators will shut down the new business line following its next examination of the bank if the examiners conclude that the bank failed to adequately manage the risks inherent in its business model.⁸

Despite the regulatory headwinds, there continue to be significant opportunities for new bank business models, although we expect to see more de facto de novo acquisitions than de novo formations over the next 12 to 18 months. Individuals interested in evaluating how best to start a “new” bank may contact any of the authors of this article or their existing Nelson Mullins attorney for more information.

^{1 See our first Build or Buy article (November 2019) and second Build or Buy article (January 2021).}

^{2 For articles regarding Community Unity Bank (Birmingham, MI) see here and here and regarding Integrity Bank for Business (Virginia Beach, VA), see here.}

^{3 For articles regarding Sonata Bank (Sebree, KY), see here and regarding Redemption Holding Company (Salt Lake City, UT), see here.}

^{4 FDIC Failed Bank List}

^{5 See link to a transcript of her speech here.}

^{6 FDIC Decisions on Bank Applications}

^{7 See, American Banker, In Farmington State Bank, some see poster child for charter stripping, August 25, 2023.}

^{8 See, for example, here for the decision issued on February 24, 2017 by the Supervision Appeals Review Committee of the FDIC in Case No. 2016-03, rejecting the appeal of a bank that had adopted a new high-risk business plan that was then criticized by the FDIC, resulting in a downgrade in the bank’s CAMELS rating and the shut-down of its new business model.}