By C. Matthew Allen

Until very recently, the “equity stack” of a community or regional bank did not look much like a stack at all, but more like a slug – namely, a slug of straight common equity. The advent and subsequent commoditization of trust preferred securities (“TPS”) diversified the typical stack somewhat, to a point now that it is common for banking companies of all sizes to have some TPS exposure (in publicly traded banks, there is about $111 billion in TPS currently outstanding). The future will see further diversification of the typical bank equity stack, and this diversification will be driven primarily by the desire to drive down the institution’s overall cost of capital, the availability of “non-traditional” bank-qualifying capital, and the desire of sophisticated investors to hold these types of securities.

The most expensive form of capital that banks carry is common equity because of the imputed rate of return that investors require to hold that riskiest portion of capital. TPS allow a bank to lower their overall cost of capital – even at pre-tax rates of 400+ bps over LIBOR, TPS rates are far below the rates required by common equity investors (rate spreads on TPS averaged about 350 bps in 2000-2002, constricted to 170 bps on average in 2006, and are expected to average 300-400 bps when the TPS/CDO markets return).  TPS have limitations, however, most notable that only 25% of a regulated institution’s Tier I capital can be composed of TPS. But are there other securities that can reduce the cost of capital even further?

As it turns out, there are, and the use of these securities – while much more prevalent in large banking companies currently – will become much more common in community and regional bank equity structures. Preferred and convertible preferred securities bridge the gap in the equity structure between common equity and TPS. Preferred security rates, while more than TPS, are less than the cost of common equity, and the inclusion of reasonable convert features will lower that rate further. Debt and convertible debt can also be used for those companies seeking Tier II capital, but the preferred security should become more prevalent because of its Tier I usability. The optimal capital structure for a regulated institution, from a cost of capital standpoint, is 51% common equity, 24% preferred stock (or convertible preferred), and 25% TPS. Employing this capital strategy will preserve the Tier I usability of all of the securities in the equity stack, minimize the overall cost of capital, and maximize the risk-adjusted returns on the common equity.

The availability of the straight preferred products will likely mirror the advent of TPS availability in the community and regional bank space. Smaller, one-off deals continue to be done, but not at a pace that would constitute a growing trend. Commoditization efforts are underway at several investment banking houses, and when the credit markets return to more normal efficiency and capacity rates these securities will become available on a much wider scale to community and regional banks throughout the country.

As the banking sector grinds through the credit cycle, current company valuations have become very attractive to sophisticated bank investors. Hedge funds and private equity firms in a sharply increasing fashion are joining the ranks of traditional bank investors. While all of these investor types express interest in owning bank capital, most are currently wary of buying the most volatile and risky piece – common equity – at this point in the cycle. Preferred and convertible preferred securities address this issue effectively by allowing investment in banks that otherwise would be unlikely to happen (within a security structure that is beneficial to all parties when compared to other possibilities). Furthermore, preferred securities are non-dilutive to common equity from a share count perspective.     

Bank capital accounts will continue to evolve as lower-cost capital structures become available in community- and regional-sized institutions. Preferred and convertible preferred securities, among others, will become much more prevalent in recapitalization scenarios and to fund strategic acquisitions. These securities allow banks to minimize their cost of capital, maximize their common equity returns, manage their stockholder bases and attract investors in uncertain economic environments.

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