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Friday, April 18, 2014

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SRC Insights: Third Quarter 2007

Supervision Spotlight: Trends in De Novo Formation

The banking industry is in the midst of an upswing in new bank or "de novo" formations. In 2006, 148 stand-alone de novo banks were chartered across the nation-the highest level since 1999 when 181 stand-alone de novo banks were formed and the third highest level since 1985 when 206 de novos were formed. In the Third District, four de novos formed last year, but seven have formed so far in 2007, and more are in the pipeline. It may seem counterintuitive that as the universe of banks steadily declines, particularly among the ranks of community banks, de novos continue to form and even proliferate during certain periods, as they are now. Why is this, and what are the implications of the current trend for established banks, especially those that experience the entry of de novos into their markets?

While the current upward trend in de novo formations appears to run contrary to common wisdom as seasoned industry players exit the scene, a closer look reveals that certain financial and market characteristics play an important role in influencing the entry of newcomers into local markets. As evidenced in the chart below, on a macro level, peaks in de novo formations have historically followed deregulation, repeals, and relaxation of state-level banking laws-which happened in the mid-1980s-and periods of economic expansion like the late 1990s.

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Research also supports a direct connection between merger and acquisition activity and the formation of de novos in specific markets. This connection is strongest where the merger replaces a small, local bank with a large, regional, or super-regional bank.1 This makes sense, given that small banks typically lend to small, local businesses and others who value personalized attention. As smaller banks (the frequent targets of merger and acquisition activity) are acquired and replaced by larger banks, former customers who value the traditional, relationship-focused banking provided by smaller banks will look for that attention elsewhere. In these markets, de novos are also more likely to find a ready supply of skilled, experienced staff displaced from the merger and acquisition activity.

While some industry analysts worry about the possible saturation of markets during periods of heavy de novo formation, studies indicate that de novos are aware of their vulnerability to intense competition and imperfect economic conditions. De novos typically target markets with a scarcity of small business lending, high population growth, a strong local economy, and under-representation by smaller banks.2

One phenomenon that has been garnering significant attention recently is the increasingly large amounts of capital that de novos have been raising. In 2006, the average amount of capital raised by de novos was $17.2 million, up 69 percent from the 2003 level of $10.2 million. Banks that start with higher amounts of capital can compete more effectively with established banks and are better positioned to lure away customers by offering better rates and more competitive pricing. The prevalence of highly capitalized de novos, however, has raised concerns among some market watchers that newcomers who have raised enormous amounts of capital are growing too fast and may overreach by booking too many risky loans, opening too many branches, and offering overly aggressive prices on loans and assets.3

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There is also evidence that institutional investors are fueling the current trend in de novo formations and playing a role in the large amounts of capital being raised. Investors risking huge sums of cash in de novos are taking their cues from others who have benefited enormously from the trend of larger banks acquiring smaller banks at substantial premiums.4 While many de novos open with the expectation of meeting community needs, it's not unheard of, for instance, for a de novo to explicitly incorporate acquisition by a larger entity into its business strategy. And while a robust capital base may serve as a cushion for operating expenses as a de novo develops and expands, industry experts agree that the more critical component of a startup's success lies in the acumen of its business strategy and the strength and talent of its management team in successfully executing that strategy.

Banks are considered de novo institutions through their fifth year of operation in recognition of the problems that can surface during this period due to inexperienced management, staffing changes (particularly in the management team or directorship), and poor lending practices. The Federal Reserve's supervision standards for de novos are intended to help startups avoid these pitfalls. The standards specify that capital levels for state member bank de novos, for example, must be reasonable in relation to state law, location, business plan, and competitive environment. More information on de novo bank formation and the Federal Reserve's standards for de novos may be found in the Federal Reserve's Application and Supervision Standards for De Novo State Member Banks.External Link

Both de novos and established banks alike face considerable challenges in today's tough operating environment, which is characterized by a flattened and sometimes inverted yield curve, margin compression, a residential real estate correction, and intense competition. Despite these difficulties, the trend toward increasing the number of de novos demonstrates that banking remains a highly attractive business and that small community banks continue to be valued by the businesses and communities they serve.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.

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