1.1 What is a Bank?

Banks are privately-owned institutions whose primary function is to accept deposits and make loans. Banks are generally used by people and businesses to store money that generates interest for the depositor, and pay bills through checking accounts. Banks can be grouped into two general categories: commercial and community. Commercial banks focus on large corporations for their lending activity while community banks focus on the local community, granting loans for cars, houses, education, and small businesses.

1.2 How Banks Create Money

Banks lend out a portion of the deposits they collect, and keep the remainder as primary or secondary reserves, which are used to pay out to depositors. Primary reserves are cash; Secondary reserves are securities banks purchase, which may be sold to meet short-term cash needs. Federal law stipulates the percentage of deposits a bank must keep on reserve, either at the local Federal Reserve Bank or in its own vault. Any money a bank has on hand after it meets its reserve requirement is its excess reserves. It’s the excess reserves that create money, through what is known as the multiplier effect. In this effect deposits are split into two categories: reserves and loans. The required reserve amount from each deposit is stored in the bank, while the remainder is used to make loans to other customers. As those loans are spent the cycle begins again, with the recipient of the money keeping a percentage for their reserves, and loaning out the remainder. As money changes hands through deposits and loans the original deposit amount multiplies, thereby “creating” money. The size of the multiplier depends on the amount of money banks must keep on reserve, which can vary depending on stipulations made by the Federal Reserve.

1.3 How Banks Make Money

Though banks are critical for economic development, at their core they are privately-owned, for-profit institutions. Banks are generally owned by stockholders, whose investments form most of the bank’s equity capital. At the end of each fiscal year a bank pays some or all of its profits to its shareholders in the form of dividends, which stockholders may choose to reinvest in the bank. Profits retained by the bank are added to the bank’s capital.

Banks earn money in three ways:

• Charging a higher interest rate on loans they make than the interest rate they pay for deposits.

• Generating interest on the securities they hold.

• Charging for customer service functions such as checking accounts, overdraft protection, financial counseling, loan servicing and sales of other financial products such as insurance and mutual funds.

On average banks earn just over 1% of their assets (loans and securities) every year, a figure commonly referred to as a bank’s “return on assets,” or ROA.

1. Selectively investing in community banks over time has rewarded many investors. Growth in earnings and the accumulation of assets are the primary considerations for organizing or investing in a new bank. Investors who buy stock in a new business venture generally make their decision after reviewing other success stories within the same industry, and those that have profited from purchasing bank stock in the past are likely to do so again.

2. The large National and Super Regional banks operating in the United States typically focus their attention on major corporations for lending activity while gathering deposits via an impersonal electronic mass marketing process. Community banks focus on small business and niche marketing, and generally take a more personalized route in the services they offer.

3. The absence of layered management and committee structures in the community bank allows for rapid decision-making, flexibility in the face of changing market conditions, and a greater responsiveness to the customer’s needs.

4. Specialization and niche marketing by a community bank can create lucrative opportunities in market areas that are neglected or not effectively served by larger banks.

5. Few community banks must support large, costly, and outmoded branch networks.

6. The Board of Directors, when composed of influential members of the community, make meaningful contributions to the bank by tapping into the community for loan and deposit business. They also influence operating policies specific to that market.

7. Individual investors tend to support the value of their investment by directing business to the bank.

8. Stock options to management and staff, and Employee Stock Ownership Programs, provide a tremendous incentive for the employees to perform with shareholders’ interests in mind.

9. Community banks, collectively, hold less than 15% of the total of America’s deposit base, leaving ample room and need for growth.

10. Deregulation has revolutionized the banking industry, giving community banks the opportunity to compete on a more level playing field, and develop new profit areas that were not previously available to them. There are now more options open to deploy their resources, offering more products and services in order to cross sell to customers.

11. Technology has helped create many new banking products, giving community banks the ability to expand their asset base faster and less expensively than with the old-fashioned, brick-and-mortar branch system. This technology hasbecome cheaper and more readily available, even to smaller community banks.

12. A pattern has emerged in the community banking industry; successful local banks are being acquired by larger institutions. These mergers are often very favorable to the bank’s shareholders, which is why potential investors should not overlook a potential exit bonus. Further, as banks are acquired or merged, the cycle is ready to begin again.

3.1 Five Phases for Building a Bank

There are five phases for opening a new financial institution, which typically take at least seven months to complete, but may take longer in some cases. A timeline of the phases is included in Appendix B, though these phases are described in detail below.

3.1.1 Phase 1: Organization

In the first phase the organizing group is formed, and comes together in preparation for an initial meeting with the Regulators. The organizing group is composed of organizers, directors, and bank management, who develop a vision for a community bank and work together to implement that vision. The pre-filing phase can take anywhere from 30 days to several months, depending on how fast the group comes together.

3.1.1.1 Selecting the Organizing Group

Selecting directors and organizers is a critical task for a new bank, as these individuals will determine the eventual success or failure of your venture. Ideally, your organizing group will be composed of a minimum of six individuals who have both credibility within their local community, and a diverse range of business experience and community contacts. These individuals should also be capable of holding a meaningful, vested financial interest in the new bank (cumulative 25-30%).

The number of directors/organizers you must have varies from state to state. In Florida, for example, you must have at least five, and there is no maximum number. In all states, these partners have to put up money as an initial offering that shows their level of commitment, and help get the bank going. The required offering amounts vary by state, ranging anywhere from 10 – 25% of the total capital needed to start the bank.

Candidates for the organizing group can be found almost anywhere, but the best approach is to look at your market area. If you plan to inhabit a rapidly growing urban area you might want to approach a well-known contractor. If the area has a large Mexican population you may want to approach a spokesperson for that community. Doctors, lawyers, financial planners, even retired persons make good candidates for the initial organizing group, provided they meet with the requirements outlined for them.

Although the initial group should be one that has similar expectations and commitment to the project, the manner with which you assemble your initial group is not as important as what you do together. Once assembled, the initial group identifies what type of bank they want to open, and what services they want to provide, before actively seeking out others to participate.

3.1.1.2 Selecting the Management Team

Once the organizing group has determined what type of bank they want to be they should begin to identify the management team including, a chief executive officer (who usually has to have past experience running a bank), President, and other executives. These are the individuals who will guide both employees and the board of directors through the banking industry in an effort to help the bank grow and prosper. These individuals should have extensive banking experience, and significant experience working within groups that initiate and implement policies. Solid knowledge of the local market and banking industry are also critical.

The regulators (the governing body that has final approval on whether or not your application is granted) place a great deal of emphasis on having experienced, competent, bankers for this role. Such emphasis is placed on the management team because it is their actions that will determine whether shareholders will see a gain or a loss on their investment. To protect the shareholders regulators need to be sure that the management team is capable not only of opening a bank, but successfully operating it, before they will grant their approval.

The greatest asset any management team can have to ensure approval with the regulators is their level of experience. Similarly, the integrity, past business histories and credit histories of these people will greatly affect the acceptance or denial of the bank’s charter. The important thing is to carefully select these partners and make sure they are team players, have the experience and know-how to help you make the bank work, and can withstand (both professionally and personally) the close scrutiny of the regulatory investigation.

3.1.2 Phase Two: Pre-Filing

The pre-filing process includes gathering information for, reviewing, and submitting an FDIC application, and a state or national banking application, depending on the type of charter you select. Both applications must include at minimum a tentative location for the proposed bank, and a list of potential directors. The application phase takes approximately 2 -3 months to complete.

3.1.2.1 Selecting Your Charter

Prior to submitting your application you must first consider what type of charter best suits your business plan. Charters authorize the organization of a financial institution by either a state or federal agency, which govern the manner in which that institution is regulated and/or operated. Such regulation is often performed through on-site examinations to make sure the bank’s financial condition is good, and that the bank is complying with banking laws.

There are two types of charters you can apply for when opening a new bank, State or Federal, each of which requires its own application. There is no requirement that a de novo institution choose one or the other; the decision is made by the organizing group according to their own preferences. State charters and federal charters typically do not differ too much in the way the bank conducts business. They do, however, differ in other areas.

Although State charters vary from one state to the next, each state has a regulatory board that governs chartered banks, and sets the policies those banks must abide by. Some states may, in addition to their own regulations, require that you are a member of and comply with regulations set forth by the FDIC, the Federal Reserve, or both.

Under an Federal charter you are governed by the Office of the Comptroller of the Currency (OCC), and you must be a member of and comply with regulations set by both the FDIC and Federal Reserve. OCC regulations do not vary from state to state, rather, they are equally and similarly enforced throughout the US, as are the regulations imposed by the FDIC and Federal Reserve.

There are both pros and cons for selecting a State or an Federal charter. For example, lending limits vary by state, and some states actually have higher lending limits than what would be permitted with the OCC. Further, some state charters may require you to be a member of the FDIC while others may not. Florida is one such example, where state chartered banks are not required to be members of the FDIC, but federally chartered banks are.

The key to selecting the best charter really comes down to preference and timing. At any given point in time the State may offer more user-friendly services than the OCC or vice versa. Similarly, the OCC could have competitive lending limits one year and poor ones the next. Some people feel state charters offer an easier application process, while others feel the consistency of a Federal charter between states is advantageous.

There is no right or wrong choice when it comes to choosing a regulatory authority with which to apply for a charter. Careful analysis of the charter application and regulatory restrictions can help you weigh the pros and cons to make an accurate decision. Keep in mind, however, that your business plan will play a large role in this decision, and, in some cases, may dictate what type of charter you choose.

3.1.2.2 Completing the Application

Once you have chosen a chartering agency you can begin to fill out the charter application and submit it (along with a lot of other information) to the state’s board of finance and banking -- or, if you’re applying for a federal charter, you’ll send it to the Office of the Comptroller of the Currency. There will also be a filing fee, approximately $15,000 - $25,000 in most states, which needs to be submitted with the application.

Before you actually file your application, it is recommended that you set up a pre-filing meeting with your selected regulatory agency. This will help make sure that you have all of the information you need to file. Usually, the biggest delays come from incomplete background and/or financial information.

3.1.3 Phase Three: Filing

In this phase bank regulators initiate their own market analysis, including interviews of organizers, and provide an analysis of and recommendations for the proposed project. The organizing group prepares responses to the Regulators’ questions, and provides any additional information requested. Once this process is complete, the bank receives its approval.

Once your application is deemed complete, a decision from the Regulators will be given within 120 days. If your charter is granted, you will usually have up to one year to open your bank. In all states, you are required to apply for deposit insurance with the FDIC before you can accept deposits from the public.

3.1.3.1 Organizer Interviews

Whether you choose a state or Federal charter, your application must include a complete disclosure of a proposed Director’s background, which the Regulators will verify during their review of your application. Regulators will also verify that all applications include a statement of authenticity or truthfulness from the applicant, as well as the applicant’s signature.

3.1.3.2 Responding to Regulatory Recommendations

In the event the Regulators dislike part of your application, you will receive documentation from them about what they disliked, and how they advise you to remedy it. Your consultant and/or economist can interpret Regulatory comments, and re-write the application to reflect those suggested changes. Once changes have been made the application is submitted again. It is not uncommon for this process to occur one or more times during the application phase, though a competent consultant/economist will reduce the likelihood of the need to submit multiple applications.

3.1.4 Phase Four: Regulatory Review

The action plan for selling bank stock is developed in this phase, while management finalizes all details for opening the bank’s doors, including necessary equipment, procedures, forms, supplies, marketing materials, and staffing. At the end of this phase, preliminary permission to open the bank is offered following a final inspection. This phase typically takes between 2 – 3 months to complete, depending on the rate at which you raise your capital.

3.1.4.1 Developing the Capital Acquisition Plan

3.1.4.1.1 How Much Will You Have to Sell?

The amount of stock you need to sell, to generate your startup capital, depends largely on your business plan (what types of services you want to offer and what funds you need to adequately provide those services, such as loans, salaries, etc.) and your market (the population, and how many shares that population can reasonably be expected to purchase). The key to this dilemma is accurate budgeting and demographic research.

Careful budgeting will help prevent the Organizers from having to cough up more money for unexpected expenses, but it is also an important stepping-stone towards identifying how much capital you need to open your bank. You don’t want raise eight million dollars in capital only to realize that since you spent $800,000 on pre-opening costs you only have $7.2 million to work with. If your goal is to have eight million to open then you have to net that amount, which means you actually need to raise $8.8 million. Budgeting will help you achieve your capitalization goals despite unexpected expenses that may arise.

Demographic research of your target market is important because some of those individuals may actually be the ones purchasing shares in your bank, and you need to know how much stock they can afford and at what price. Additionally, you need to determine what services they look for, and what it will cost you to provide those services, if you want to adequately meet their needs. Having a clear idea of what people want and what you can provide will help you determine what monetary resources you need to support your business plan and open the bank.

Most people who have been through the de novo process before will tell you that they’re scared to open a bank with less than ten million, however, the actual amount of capital you will need will be determined by your marketplace and business plan. Your experts such as economists, consultants or lawyers should be consulted before making a final decision, because they should have specific knowledge of the banking industry in your area.

3.1.4.1.2 How Many Shareholders Will You Need?

Once you’ve determined how much capital your de novo bank will require, you should begin to consider how many shareholders you would like, or are permitted to have. A good rule of thumb is that the more shareholders you have, the more potential customers you have. People who invest in your bank by purchasing stock have a financial stake in the success of the institution, and, if they are smart investors, will do what they can to protect and grow their investment.

There are two ways shareholders can ensure the bank’s success; opening their own accounts, and referring their friends. Therefore, it stands to reason that if you have three hundred shareholders you will have approximately three hundred customers. Further, if each of those customers tells two or more people about the bank, your depositor base can grow exponentially.

One factor that may affect the number of shareholders you have is the amount of money each invests. If you plan to raise ten million and each investor puts up only five thousand, you could theoretically end up with two million investors. Conversely, if each investor puts in five hundred thousand you could end up with only twenty investors. It is for this reason that most proposed banks have a minimum investment level of between two and five thousand dollars, and a maximum investment level of between two hundred fifty and three hundred thousand dollars. These parameters help control the number of shareholders, and play an important role in anti-gorilla management.

As with any other organization that lets the public invest, any shareholder owning more than fifty percent of the bank’s stock can have the ultimate decision when it comes to mergers, acquisitions, and offers to sell. Limiting the amount of purchases prevents any one shareholder from having that ability, and helps the bank remain in the hands of the community, where it was intended to belong. Limitations on stock purchased should apply to investors, directors, and management alike if these anti-gorilla measures are to be adequately enforced.

If your institution votes to implement such restrictions on stock purchases, the minimum and maximum guidelines are yours to determine. However, before a decision is made you should consider the demographic research to identify a reasonable minimum investment level for that area, and a maximum investment level that places shareholders far below any benchmarks that would give them control of the majority of the stock.

3.1.4.2 Finalizing the Operating Details

3.1.4.2.1 What Needs to be Accounted For?

In this phase the project has been granted permission to sell stock, and is authorized to accept investments. The organizers and senior management actively engage members of the community to invest in the bank through a series of community meetings designed to educate the community on the new bank and the investment opportunity it represents. This phase can take anywhere from 3 months to one year, even longer if the group seeks an extension to sell stock after the initial subscription period has expired.

3.1.5 Final Phase: Capital Acquisition

Once the operations have been finalized and the capital has been raised, the Regulators will conduct a final field interview to ensure the bank is ready to accept customers. Upon the passing of that test the bank is granted a charter and can open for business.