A Troubled Bank in Texas – Part I

Editor’s Note: A version of this story ran in the San Antonio Express News and Houston Chronicle on September 17 2023. Since this is an ongoing (and soon to be updated story) I figured Part 1, although a few months late, needed to be posted here.

Following the 2nd, 3rd, and 4th largest bank failures in US history – that all occurred in Spring 2023 – a natural question is: What happens next? 

I’ve never thought it likely that only failed banks First Republic, Silicon Valley, and Signature made major errors last year when the Fed aggressively hiked rates, while the other 4,697 banks in the country did not. Only one other tiny bank in Kansas has failed since then. It’s the dog that, eerily, hasn’t barked in the night.

Industry Bancshares Inc is made up of 6 smaller banks in rural Texas counties

Industry Bancshares Inc, has 6 subsidiary banks and 27 branches just a few hours’ drive from each other in the rural counties between the Texas triangle formed by Houston, Dallas, and San Antonio.

The six subsidiary banks of Industry Bancshares, Inc are Citizens State Bank of Buffalo, TX, Bank of Brenham NA, Fayetteville Bank, First National Bank of Bellville, First National Bank of Shiner, and Industry State Bank of Industry TX.

Industry Bancshares Inc Org Chart, as of 2019

Since at least December 2022, and including through their latest public filing of financial data in June 2023, all six of the banks that together make up Industry Bancshares has reported a significant negative net worth, using traditional accounting standards.

Bank Solvency

I don’t mean to be alarmist. Like shouting “fire” in a crowded theater, shouting “insolvent!” in a crowded bank lobby is neither kind nor prudent. Hopefully you watched the movies “Mary Poppins” and “It’s a Wonderful Life” so you have an intuitive sense for the fragility of all banks, especially to the extent that the FDIC only guarantees deposits up to a certain point. 

its_a_wonderful_life
From: “It’s a Wonderful Life”

The people who should be alerted to the financial stats I’m citing, however, are the 3,216 depositors at these 6 banks who have a reported $2.2 billion in accounts over the $250 thousand FDIC guaranteed limit, as of June 2023. This post is aimed specifically at those folks with billions of dollars in under-insured deposit accounts. Shareholders and board members of course should stay alert as well.

A spokesperson for Industry Bancshares Inc responded to a series of my questions, “Industry Bancshares, Inc. and our six chartered banks have capital levels that significantly exceed the required regulatory minimums, are financially strong and well positioned in the current environment to continue to serve our customers throughout the communities we operate in Texas.”

Not credit mistakes, but interest rate mistakes

Unlike past banking crises, the banking crisis of 2023 is not about losses in credit portfolios, meaning loans banks made to businesses or real estate that went sour. Industry Bancshares in fact has a pristine loan portfolio, with each subsidiary reporting less than 0.25 percent of non-performing assets at the end of 2022. This is very clean.

Instead, banks are showing losses on their bond portfolios. Most banks hold lots of bonds, and most bonds lost money in 2022, when interest rates went up quickly. So most banks have losses to report this past year on their bond portfolios. Banks publicly report, every quarter, how much they’ve lost (or gained) on bonds that they hold. 

Says the bank’s spokesperson, “Over the past 30 years, our bond portfolio strategy has enabled us to maintain strong earnings and bolster our capital position. The bond portfolio is comprised of high-quality, performing investments such as U.S. government treasuries and agencies and highly rated Texas municipal securities. The current unrealized losses in our bond portfolio are just that – unrealized. Our high credit quality, highly rated bonds continue to perform as agreed.”

Federal Reserve of Dallas overseas bank holding companies

The bank declined to respond to my question about what changes if any have occurred in the bond portfolio, or the value of the portfolio, or hedging strategy, or interest rate posture since the bank last publicly reported numbers on June 30, 2023.

An outlier in AOCI

The losses that banks have on many of their bonds classified as “available for sale” are reported as an accounting line item called “Accumulated Other Comprehensive Income” (AOCI). In plain language this means “how much are our bonds worth today, if we were forced to sell them, compared to when we bought them?” If they are worth less today, then AOCI is a negative number.

Two other important accounting line items matter to this story, before I explain how much of an outlier Industry Bancshares is among US banks. 

First, banks calculate and report their net worth in two different ways. One is called “Total Equity Capital” and is calculated according to regular business accounting standards (aka generally accepted accounting principles, or GAAP.) You could think of this as the difference between what they own, and what they owe. Standard stuff for how we would calculate the net worth of any business.

A different calculation is called “Common Equity Tier 1 Capital” (aka CET1) which follows specific bank regulatory rules, and it basically allows banks (and their regulators) to more or less ignore bond portfolio losses, in most cases. When a regulator looks at CET1 instead of GAAP results, a bank will look fine, even as it reports extraordinarily negative AOCI numbers.

Here’s where Industrial Bancshares’ quarterly reports from June 2023 are very interesting. (What I mean is now is the point to unglaze your eyes from my accounting lesson, and sit up straight in your chair.)

Industry Bancshares’ Unusual Situation

Using data from official bank accounting reports, just a mere 15 banks in the entire country had a negative “Total Equity Capital” number at the end of June 2023. Interestingly, the top 5 worst banks on the list, or in other words the banks with the lowest net worth on the list of 4,697 banks in the country are actually part of the same bank holding company. Number 7 on this ignominious list is also part of the same holding company. Yes, you guessed it, they are the 6 banking subsidiaries of Industry Bancshares Inc of Texas. All 6 subsidiaries have a negative net worth, and as a result so does the consolidated bank holding company. All-in, Industry Bancshares is currently supporting $5.8 billion in assets but has a combined “Total Equity Capital” of negative $128 million, as of its June 2023 report, or $108 million at the holding company level.

Line 15 from June 30 2023 FR Y-9C for Industry Bancshares Inc shows negative $108 million net worth on a GAAP accounting basis

In the plainest language, what does negative total equity capital mean? It’s not just an accounting problem. If depositors and lenders to the bank all wanted their money back tomorrow, and if the bank managed to sell all of their assets (including their bonds) to give that money back, negative equity simply means there wouldn’t be enough money. In simplest terms, they’d be short $128 million. At current prices, their bonds lost so much value last year that there isn’t enough to cover depositors and lenders to the banks. And the bonds didn’t recover enough in the six months from December 2022 to June 2023. They reported negative $159.7 million total equity capital in December 2022.

The fact that there are only 15 banks out of 4,697 in the country with a negative net worth, but 6 of those banks are actually the same bank holding company, makes Industry Bancshares a strong outlier on this measure, according to publicly reported data in June 2023.

And look, I’m not your licensed financial advisor, and your mileage may vary, but personally I like to bank with an institution that has a positive net worth. Actually I’d be fine because, sadly for me, I don’t have balances over $250 thousand at my bank, but you know what I mean.

In response to my query about their $2.2 billion in 3,216 underinsured deposit accounts as of June 2023, the spokesperson for the bank replied “We have a growing, diverse, stable, and loyal deposit base. Our team of bankers use their experience and industry best practices to counsel our customers on how to safeguard their large cash balances…With six chartered banks we can increase FDIC insurance for customers across our affiliates. In addition, we utilize IntraFi Network, a solution that helps bank depositors access FDIC insurance above $250 thousand, to ensure our customers have access to FDIC insurance coverage.”

Another independent ranking

Bauer Financial, a bank rating group, assigns ratings every quarter to banks based on their financial strength.

In their June 2023 ranking, five out of 487 of banks in Texas merited 2 out of 5 stars, indicating a rating of “problematic.” Twenty-three banks out of 487 got 3 stars, indicating “fair” financial health. All 6 subsidiary banks of Industry Bancshares received 3 out 5 stars in June 2023. That’s a rating on par with San Antonio-based insurance and banking giant USAA. Although Bauer is indicating some cause for concern, they are not highlighting Industry Bancshares as an outlier the way the AOCI measurement I cited does.

Bank ranking company

So why haven’t regulators shut them down?

So if these banks are such outliers, when considering their bond portfolio losses and their overall business value, and this information is known and public, why do regulators allow them to be in business? 

I mean, one would assume and hope regulators are paying attention. The Dallas Federal Reserve would have responsibility for the bank holding company. In response to my query, the Texas Department of Banking replied formulaically that they could not comment, among other things, on “information related to a regulated entity’s financial condition or business affairs.” 

So I’ll speculate instead. The answer is likely a combination of: 

1. A bank accounting technicality,

2. A purposefully gentle treatment of bond portfolio losses by regulators, and 

3. Depositors over $250 thousand being blissfully unaware of the risks they currently run.

The bank accounting technicality issue is that regulators essentially have turned a blind eye to AOCI losses, and instead use the special banking health measure – CET1 – that ignores it. The thought process I guess is that as long as banks don’t have to sell their bonds at current market prices, they do not have to lock in their losses. And if depositors don’t flee, and the bank doesn’t sell the bonds at a loss, and other problems don’t crop up like credit losses, everything is fine in the long run. 

The regulatory treatment of CET1, which ignores bond losses, allows the spokesperson for the bank to truthfully say in response to my query: “We have increased our Tier 1 leverage capital levels in each of the last 15 years, and in 2023 those levels have continued to increase. As of July 31, 2023, Industry Bancshares, Inc.’s Tier 1 leverage capital is 11.7% and total risk-based capital is 29.7%, which is in the 99th percentile of our peer group and is well above the regulatory definitions of well capitalized.” The bank, like regulators, focuses on CET1.

Page 54 of June FR Y-9C. Showing positive CET1 capital of $676 million and healthy 11.5925% leverage ratio. This is likely why regulators have given Industry Bancshares a pass in 2023, as CET1 ignores bond losses.

In fact a special program called the Bank Term Funding Program was created in March 2023 in the wake of the Silicon Valley and Signature failures – failures due to their bond portfolio losses and subsequently depositors fleeing! – to save banks from having to abruptly sell their bonds if they started to lose depositors or needed liquidity for any other reason. It’s a program put in place on an emergency basis that shields banks from the consequences of their losses on their bonds. In plain language, under this program, banks can borrow from the Fed against their bonds in amounts just as if they haven’t had any losses. In the banking world there’s a concept called “extend and pretend” that banks sometimes offer to their borrowing customers who have trouble paying back their debts. This program is a bit like the Federal Reserve offering “extend and pretend,” but for banks with bond portfolio losses.

The positive case for Industry Bancshares

What could a bank like Industry Bancshares, Inc and its subsidiaries do in this scenario to improve their lot and protect their uninsured depositors? The prudent short-run solution is to either merge with a stronger bank or sell to a stronger bank. Were I the acquiring bank, I would look very closely at the negative net worth and bid accordingly. Acquiring banks understand bank accounting very well.

Another short-term fix is to raise more capital from investors, which can then be used as a cushion against losses or fleeing deposits. Industry Bancshares last raised equity capital in 2017, according to SEC filings. Were I a current or prospective investor, I’d want to know their current position, but maybe they already do? The bank declined to respond to my question of whether it had sought to raise additional capital to bolster its negative net worth.

Were I an uninsured depositor with a commitment to sticking with one of these banks, additional capital would be the main thing I’d demand. The bank did not to respond to my question of whether the bank had paid investors dividends in 2022 or 2023. Documents I reviewed showed the bank did pay dividends to investors at least from 2014 to 2019. 

The long-term fix, or no fix at all, is to wait. Given enough time, a successful bank franchise can earn money and climb its way out of a financial hole. Not counting their bond losses, the combined banks earned $76 million in 2022. At this pace of earnings, and assuming no change in their bond portfolio, they could climb back to a roughly breakeven, a zero net worth, in about two years.

Their bond portfolio may recover in time. As long as depositors do not flee and regulators give them time, these banks may eventually survive and thrive. But for anyone with more than $250 thousand in your account, you’ve been warned.

Please see related posts:

USAA Bank reports 2022 results – Not Great

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Bummer About All That Cash, Man

MJ_Cash

MJ_CashOne of the hottest-developing industries in the US, marijuana-related businesses, is still practically shut out of the modern payment system because of an unusual patchwork regulatory situation. The result is that dealing with the cash, banking, and financing parts of this business are stunted and twisted into strange shapes.

Schedule 1 Substance

The root of the weird regulations and patchwork solutions is that federal law classifies marijuana as a “Schedule 1” substance, the same as heroin, ecstasy and LSD. Even though marijuana is legal for recreational use in 9 states and for medical use in another 31, regulated financial institutions really, really don’t like the risk of dealing with businesses making money from a Schedule 1 substance. They can’t afford to run afoul of federal laws and regulations. Even in legalized states, sometimes as few as one bank in a whole state, and never more than a handful of banks, offer traditional deposit-taking banking services to marijuana-related businesses.

In addition, major credit card companies like Visa, MasterCard, and American Express consistently refuse to process any payments from any company that touches the product. That means retail customers can’t ever pay with credit or debit cards. Even new fin-tech person-to-person payment services like Venmo, PayPal, and the Cash App regularly shut down services for marijuana-related businesses when they catch a whiff of it. Bank-based lending to the industry essentially does not exist either.

And remember, the industry is not just retail stores, but everything that touches a marijuana plant, from growers to cultivators to processors to cartridge makers to transporters to retailers. It all operates at the fringes of the traditional banking, payments, and finance sector.

Necessity Meets Invention

Morris Denton, CEO of an Austin-area medical cannabis dispensary Compassionate Cultivation, the first licensed dispensary in Texas, confirmed to me that the banking and finance side of running his business remains “a big pain in the butt.” Very few banks are willing to either take the risk or engage in the regulatory headache of working with businesses like his.

Sometimes out of necessity comes invention. For example, a Scottsdale, Arizona-based fin-tech and reg-tech company called Hypur offers a suite of products for the few banks and credit unions willing to serve the industry. As a finance nerd interested in the way traditional banking operates and evolves, the Hypur offering sounds kind of radical and awesome.

As VP of Hypur Tyler Beuerlein describes it, their data and software feed allows a bank to monitor, in real time, every single transaction of their marijuana-based business customers. According to Beuerlein, this super-intrusive data feed is what’s necessary to lower the risk that banks face when dealing with the industry. From a compliance perspective, they empower the marijuana-industry serving banks to know the source and size and timing of every single customer transaction. According to Beuerlein, if a marijuana business made exactly $23,750.22 in sales today, their bank (via Hypur’s data feed) can know that precise amount in real-time.

Cash Problems

To understand both why that’s cool and different, you have to picture some of the tremendous complications that come from a nearly all-cash industry. And also picture the fairly weak information banks typically get from their small business customers.

Cash-based transactions – far less traceable than electronic payments – create a whole series of risk for banks, already super-anxious about federal regulations. How do you prove to the feds the source of a business’ cash is legitimate? How do you comply with anti-terrorism laws? A successful marijuana business typically manages big piles of cash that can’t be easily dealt with.

marijuana_legalizationFolks in the legal (and quasi-legal) marijuana industry describe strange problems that arise when you run an all-cash business. Like, vaults full of paper money that require powerful fans to keep the money from getting wet and rotting. Over time that cash literally tends to stink like marijuana. One industry veteran described a man who dug a hole for a shipping container in his backyard that he filled with currency. As every bar manager knows, cash has a nasty habit of walking out the door at the end of the night in the pockets of your employees. Big piles of cash also attract thieves who can target your cash at your business location, or when the money is in transport.

Banks in the US generally will not let you initiate large deposits of cash if you cannot account for exactly where it all comes from. Even if the bank agrees to work with you, you can’t simply show up with your previously earned $40,000 in cash and expect the bank to open up your business checking account.

We can all imagine the problems of consumer all-cash transactions, but business-to-business payments are likely even more a hassle, since they’re that much bigger.

When I listen to a description by Beuerlein of Hypur’s data-feed to banks that serve the marijuana-related businesses, it’s interesting to think about how every bank that serves small businesses would in theory want this, even outside the marijuana industry.

Typically banks that make loans to small businesses get very sketchy, partial and intermittent information. If a loan is paid on time, a bank might request a copy of annual tax filings. If a problem arises, maybe the bank demands quarterly or even monthly accounting statements from the business. Those statements are going to be voluntary, prepped by the businesses, and frankly leave a huge amount of discretion to the business owner on what gets reported. It’s interesting – ok, maybe just to finance nerds like me – to think about the banking possibilities of seeing real-time transactions of a borrower. To a banker, that’s like the holy grail of lending.

One of the ironies of heavy business regulation – like what currently weighs on the marijuana business – is that it actually spurs entrepreneurial solution-seeking. When regulation creates enough pain points for businesses, other businesses will step up to try to solve those problems.

Meanwhile, when the Schedule 1 classification gets lifted, this whole regulatory problem changes and mostly goes away. Of course I don’t know if that’s happening 1 year or 10 years from now. (hint: It’s closer to 1 year than 10 years.)

A version of this post ran in the San Antonio Express News and Houston Chronicle

 

Please see related posts:

 

The business case for marijuana legalization – January 2018 – With a Beto O’Roarke Cameo!

Legal Pot in Texas – The Money Case – February 2016

Weird tax laws around marijuana businesses

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New and Old Ideas For Fixing Banking

Kirsten_Gillibrand_postal_banking

 

Kirsten_Gillibrand_postal_bankingTraditional bankers won’t like this blog post. But you know what? Many people don’t like their own banks, and many people aren’t being served well by our banking system. I’m intrigued by recent proposals to fix a gap in the deposit-taking function of banking, specifically a US Postal Bank on the one hand, and an even more disruptive idea of a Federal Reserve bank account – known as a FedAccount – available to individuals and businesses.

Postal Banking

Senator Kirsten Gillibrand (D-NY) introduced a bill in April to revive US Postal Service banking, something that we used to have. It began in 1910 under President William Howard Taft until it was ended by Lyndon Johnson in 1966, according to banking scholar and University of George law professor Mehrsa Baradaran, in her Ted Talk on postal banking.

How_the_other_half_banksIn the Gillibrand proposal, the Post Office would offer free deposit accounts for amounts up to $20,000. For-profit banks tend to ignore small depositors as unprofitable, or they charge high checking account fees to make up for that unprofitability.

The Post Office already has branches everywhere, including in “banking deserts” that have been abandoned by community banks as unprofitable, and where check cashers and payday lenders have moved in. While the Post Office by charter must be financially self-sustaining, it has a history of subsidizing services for the public, as it does for example when it unprofitably delivers mail to remote rural areas.

In Gillibrand’s proposal, personal loans of $500 could also be offered. Her proposal came with an unreasonably low rate for this type of personal loan. But even at rates as high as 20 to 25 percent, it wouldn’t be hard to offer an interest rate that reflected the risk of these loans, while still undercutting payday lenders.

The people who would be most helped by postal banking are the estimated 10 million US households who are “unbanked.” Among the very poor, up to 10 percent of disposable income gets used for basic financial services, such as check-cashing and payday loans.

The FedAccount

But how about an even more intriguing and radical solution proposed last month, that would help not only the poor, but the wealthy and everyone in between from small businesses to you and me?

The proposal by three economists and former US Treasury officials is to offer a FedAccount – free checking accounts of any size at the Federal Reserve to individuals and business. The Federal Reserve currently only has deposit accounts for financial institutions.

Capital_One_KittyIn a fiat money system like ours, as you hopefully already know, money is a kind of collective fiction we all weirdly agree to. The beautiful thing about the Federal Reserve is that they are the dream weavers of this fiction. They invent money. An electronic ledger in a FedAccount with your money will always be there basically because the Federal Reserve says it’s there, and they perform magic.

When you can invent money there’s no problem whatsoever guaranteeing unlimited amounts of money both to the under-banked poor and the extremely wealthy. A $100 deposit by a poor person will always be there. A 100 million deposit by a wealthy person will always be there. 100 percent guaranteed.

The FedAccount could also handle merchant processing for free between FedAccounts, something that businesses currently pay extraordinary amounts of money to credit card and debit card companies to do. Small businesses in particular, with little negotiating power against credit card companies, could reap huge savings on processing fees. Eliminating those fees would ultimately lower costs for consumers. Also, a business using its FedAccount should be able to receive payment on the same day, which could be a life-saver to cash-strapped businesses.

Is a FedAccount a threat to traditional banking as currently provided by a combination of megabanks and smaller private community banks? I don’t think so. If the Fed Account stayed out of the lending business it should not threaten legacy banks.

FedAccountWhat about costs to create the program? The Federal Reserve already keeps deposit accounts for all banks, so adding that capability for individuals and businesses would be simply a matter of straight-forward software programming.

How could this all be free? The Federal Reserve earns profits on financial assets it owns, and sent $98 billion, $92 billion and $80 billion in excess profits to the US Treasury in 2015, 2016, and 2017.

Would it need an army of customer-service employees? Doubtful.

With an easy phone app I know it could attract most of my deposits. I don’t need to talk to banking employees about my account. When was the last time you had an important and helpful conversation with a bank employee regarding your checking account? I’m guessing for most of us, approximately, never?

I can anticipate a libertarian aversion to these expanded government-as-banker roles. Would government banking be competent? Would it protect privacy? As the proposers of FedAccount argue, the Treasury processes billions of payments per year, and disburses millions of Social Security checks per month, basically without a problem.

The Federal Reserve handles $3 trillion worth of Fedwire payments per day. They’re good at this stuff. Unlike the private banking sector, which has to be regulated and subsidized to keep it from periodically failing, the Federal Reserve doesn’t need a subsidy and implied public bailout. Remember, it can create money virtually whenever it needs to. It’s magic.

On the issue of privacy and government intrusion, the FedAccount would be an option, not a requirement. People who fear government intrusion could continue to only patronize private banks.

Look, I wouldn’t bet a single dollar of mine that the low-cost, needed, solution of FedAccounts will happen in our lifetime. We’re talking about something that would make every for-profit banker in the country nervous. And nervous bankers make for a powerful lobby. But I’d be up for it.

The US Postal Bank as proposed by Gillibrand is more modest in scope and has a successful historical precedent. That one’s not impossible in the medium term, and it’s also worth trying.

A version of this post ran in the San Antonio Express News and Houston Chronicle.

 

Please see related posts:

Book Review: The Color of Money by Mehrsa Baradaran

Interview with author Mehrsa Baradaran

Why You Hate Your Bank

Another Reason You Hate Your Bank

 

 

 

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