In this post, I’ll consider the risks of buying an existing bank. All of these issues must be considered before buying a bank in Puerto Rico or elsewhere. The primary risk areas when buying an operating bank in Puerto Rico are compliance, the bank’s loan book, and regulatory issues from prior transactions.
I often hear from clients that they must have an operating bank and that they don’t want to buy a license and spend the time to build out a bank from scratch. Here is why buying a bank is fraught with risks compared to purchasing a banking license and why I always try to recommend buying a license over an operating bank in Puerto Rico.
In the dynamic world of finance, buying a bank can be a strategic move that might yield significant profit. However, it’s a complex process that comes with substantial risk. Prospective buyers need to understand the potential pitfalls and challenges associated with this acquisition, including the risks related to the loan book, compliance fines, and regulatory risks from prior transactions. This article will explore these risks in detail.
Understanding the Risks of the Loan Book
One of the biggest risks when buying a bank revolves around its loan portfolio, or “loan book.” This collection of loans that the bank has issued and is still owed is a significant source of income for banks through interest payments. However, if the borrowers default, it can lead to significant financial loss.
The loans’ quality can vary, and risky loans might be hiding among numerous healthy ones. For example, if a bank has lent money to many subprime borrowers or sectors going through an economic downturn, the likelihood of these loans defaulting is high. These “non-performing loans” can drastically affect the bank’s profitability and, ultimately, the investment return for the new owner.
Banks are in the business of making loans, which provide profits through the interest charged on the borrowed funds. However, where do banks get the money to lend? The answer is simple- from customer deposits. Every time a customer deposits money into a bank, the bank essentially gains access to that money, which they then use to fund loans for other customers.
As is with any kind of lending, there are always risks involved, no matter how well-researched, managed, or executed a loan may be. This risk becomes even more apparent when bank clients default on their loans. Defaults increase the risk of loss for banks as they may not recover the borrowed funds along with the accumulated interest. In such a scenario, the money of other bank customers, that is used to fund the loans, is put at risk.
This is why banks must maintain certain levels of capital reserves, which is essentially a safety net that enables them to absorb losses in case of defaults. However, if these reserves get depleted, the bank may be forced to call in loans or even close its doors. Therefore, banks must always ensure that the borrowers have the capacity to repay their loans, and the due diligence process prior to lending is integral in maintaining the overall financial health of the bank.
In addition, many of the loans made by international banks in Puerto Rico are secured by real estate outside of the United States. Unless the buyer is experienced in the laws and litigation procedures in the country where the asset is located, they may not be able to determine the risk or their ability to seize the asset to pay the debt and reclaim customer funds.
Before making a purchase, it is crucial to conduct thorough due diligence to understand the loan book’s composition and quality. This investigation can reveal hidden risks and potential losses that may affect the bank’s valuation. This is especially true when buying a relatively small international bank in Puerto Rico.
Compliance and the Risk of Fines
Financial institutions operate within a heavily regulated environment. This reality means that they must comply with numerous laws and regulations, both domestically and internationally. Non-compliance can lead to substantial fines and penalties that can severely impact the bank’s financial health.
In recent years, regulatory authorities have significantly increased their scrutiny of financial institutions, leading to more frequent and substantial fines. Some of these penalties are for non-compliance issues that occurred years ago, meaning a buyer could inherit a ticking time bomb of potential fines.
Regulators in Puerto Rico have become very aggressive in handing out fines when a bank is out of compliance. I often see a small bank get out of compliance because they can’t afford the costs of a quality system or hire sufficient people to properly review account openings and transactions. This is especially true when a bank is losing money and looking to sell.
Prior to purchasing a bank, it is essential to carry out comprehensive compliance checks. Understanding the bank’s compliance history, current practices, and potential areas of concern can help to mitigate this risk. Prospective buyers should also consider the bank’s culture around compliance, as this can be a significant factor in future compliance issues.
Regulatory Risks from Prior Transactions
In addition to the risk of inheriting past compliance issues, a new bank owner might also inherit regulatory risks from prior transactions. These can include transactions that are under investigation by regulatory bodies or those that could potentially lead to future investigations.
For instance, the bank may have been involved in controversial practices, like facilitating money laundering or financing prohibited activities. These activities could attract significant regulatory penalties and reputational damage, significantly impacting the bank’s value and the new owner’s return on investment.
Before acquiring a bank, it’s critical to investigate its past transaction history. This investigation should include a forensic audit to identify any suspicious transactions, and consultations with regulatory experts can help to understand potential regulatory risks.
Buying an operating bank rather than a license will speed up the time to market, but it is not without risk. The risks associated with the loan book, potential fines for non-compliance, and regulatory issues from past transactions should all be carefully considered and investigated before any purchase. A failure to understand and manage these risks can lead to significant losses or the revocation of the license.
I would also like to note that small underfunded banks in Puerto Rico typically have low-cost and inefficient core systems. Replacing those systems can be a 6-month process… though, I will leave this for another article.
If you are considering buying a bank in Puerto Rico or elsewhere, please contact me at email@example.com. I will be happy to assist you and guide you through the process.