When Government Overreach Becomes Profitable

By TradeSmith Editorial Staff

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Earlier this year, the Senate Finance Committee announced plans to dig deep into Americans’ bank accounts to curb tax evasion. Initially, Senate leaders proposed that banks report directly to the Treasury Department information on any bank account that has inflows or outflows of $600 or more.

Because critics called this too intrusive, last week the Senate proposed it would increase the threshold — with exemptions for wage income — to $10,000.

Now, Congress says this is necessary to stop billionaires from cheating on their taxes.

But anyone who might buy a home, start a business, or win a high-stakes poker game will be collateral damage. Radio hosts are calling this government overreach. Television pundits cry that this is yet another effort by bureaucrats to poke their noses into citizens’ affairs.

Me? I call it an opportunity.

Compliance Costs Go Boom

If you have a bank account, this likely impacts you.

But who pays for the compliance?

The bank does.

Now, when most investors think about the financial sector, they tend to only think about JPMorgan Chase, Bank of America, and the other megabanks.

I want to remind you that there are three tiers of banks.

There are the megabanks. Then there are regional banks like PNC Bank, M&T Bank, and Fifth Third Bank.

Then there are the community banks. These banks have market capitalizations under $2 billion, but most of them are under $1 billion. These banks are where the opportunity lies ahead. You see, community banks face the same compliance costs as their competition at the national level.

That alone creates a challenge. You see, these banks face steep demands from their consumers to match the functionality of larger banks. They must invest in digital technologies; they must invest in cybersecurity; they must ensure that their customers can access cash through ATMs at low costs. Otherwise, they might lose their business.

Banks already have extremely high compliance costs. According to Ascent AI, a company that helps businesses automate regulatory compliance, the average mega or regional bank pays roughly $10,000 per employee in compliance costs alone. That means a bank with 20,000 employees might pay upwards of $200 million each year on compliance alone. Following the 2008 financial crisis, Ascent says that the average corporate and regional bank saw a 60% increase in operating costs due to compliance requirements.

In addition, cybersecurity threats have required banks to dramatically increase their defense costs. And legislation like what the Senate is proposing is making it more difficult for banks to operate.

Now, let’s add on a new compliance cost. Any account that sees inflows or outflows of $10,000 or more (minus income) will require reporting to the government. This creates increased demand for compliance officers in an economy where wages are increasing dramatically.

What are community banks to do then? Based on history, they will likely sell themselves.

Community Bank M&A is a Massive Trend

Back in 1987, there were roughly 15,000 banks in the United States.

Today, there are fewer than 5,000. We didn’t see 10,000 banks go out of business. Instead, we saw bank mergers and acquisitions (M&A) pick up over the last 25 years.

Several trends have pushed M&A in the space over that period. First, compliance costs are naturally a trend. In addition, community banks have struggled to attract younger talent. Simply put, the average 25-year-old finance major would rather move to New York and work for Morgan Stanley than work for a community bank in Lincoln, Nebraska.

As a result, several community banks have older boards that are looking for an exit. So selling the bank simply makes sense.

Of course, the biggest trend is the most obvious, if you understand how banking works. Remember that banks need large amounts of deposits to lend capital to businesses or consumers. So there are only two ways for a bank to increase its deposits.

The first is population growth and an uptick in that population’s wealth. States like Arizona and Florida have seen a big population increase in recent years. With more people moving to the Sun Belt, there is also more capital flowing into that region. That is positive for the banks that have seen an increase in deposits.

But places like Illinois and New York have seen populations slide. With more people leaving, the banks in those regions can’t rely on such growth. So they use the second method for increasing deposits: buying deposits by purchasing other banks.

Consolidation has accelerated in places where population growth has been stagnant, like Maryland and Massachusetts.

How to Play Consolidation in the Banking Space

The markets might be at all-time highs, but the community banking space is one of the rare places where value exists. If you want to take part in this trend for the future, here is how to do it.

You will want to purchase community banks that trade at a price-to-tangible book value under 1. The tangible book value of a company is the price it would be valued at should the company liquidate today.

I want you to think about this trade in a very simple way.

Imagine that a bank has no debt and $1 million in its vaults. So the bank would be worth $1 million.

But the stock market — because of its irrational nature — values this same bank at $800,000.

That means that the bank is trading at 0.80 times its tangible book value.

It sounds ludicrous, right?

Well, there are 30 community banks with a market capitalization under $1 billion that trade at a price-to-tangible book value under 1. So value investors can buy the cheapest ones and wait.

Tomorrow, I’ll dig deeper into this list and look for community banks that have improving momentum. But, again, this is a winning trend. It simply requires patience.