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Should you work with a start-up bank?

Start-up banks seem to be opening on every corner. Known as de novo banks, these organizations promise customers a more personal level of service than bigger banks - sometimes with more risk. Should you and your midsized organization do business with a de novo bank?

Technically, a de novo bank is one operating for five years or less and subject to special supervision standards. Your local, independent, community bank might qualify as a de novo bank. The de novo business model is based on traditional banking services: taking deposits and lending. Many large banks now focus on generating noninterest income from services such as asset management, insurance, investment brokerage and investment banking.

Familiarity a selling point

A personal relationship with the head of the bank is key to the de novo sales pitch. In many cases, customers deal directly with the bank president or owner.

If you decide to work with a de novo bank, you very well might be working with a banker you already know. Bank consolidation is fueling the de novo bank trend, creating gaps in the market and displacing experienced bank executives who are in a position to raise money to obtain a bank charter. (According to the FDIC, there are roughly half as many banks today as there were at their peak in 1984.) In many cases, these executives set up new banks in the same areas they previously worked. This familiarity is a definite advantage in deciding where to bring your company's lending business.

"When I interview potential employees from large banks, I find that they are compensated based on transaction volume," says Jimmy Walker, CEO of North Atlanta National Bank. "A community bank typically measures its officers on the number of relationships managed - implying that ongoing service matters. Accordingly, I would say success is totally based in our business relationships as opposed to any products we offer."

Going further for your business?

De novo banks sometimes finance projects bigger banks won't touch. Often, big banks won't look at business loans below a certain dollar amount.

"The clients of big banks cannot meet those banks' risk-adjusted return-on-capital thresholds unless they are doing some type of fee-based business with the banks," Walker says. These thresholds keep many good business plans from getting off the ground.

Often, a big bank's internal economics are a roadblock to both lending and sharing expertise with small and midsized businesses. Having more insight into smaller businesses enables de novo banks to accept risks that many big banks are unwilling to explore.

"For example, we often take on a new business that lost money in prior years if we understand the loss, believe the underlying factors have been addressed and like the way the owner responded to the challenge," Walker says. "The big-bank scoring model simply says, 'No - you lost money.'"

Mutual risk

De novo banks are often just hungrier for your business. Does that make them more susceptible to failure? In Walker's insider view, the financial health of a de novo bank shouldn't be a deciding factor on where to take your business unless you are a very large depositor or an interested investor.

The regulating community agrees. According to a recent report by the Economic Research Department of the Federal Reserve Bank of Chicago, the estimated failure rates and acquisition rates for de novo banks are initially similar to those estimated for established banks. But as de novo banks age - consuming their start-up capital and outlasting legal restrictions on purchasing new banks - they become substantially more likely than established banks to fail or be acquired. The de novo bank failure rate rises to almost five times the established bank rate before declining back to "normal" levels after about a decade. Failure rates also depend on the alignment of a de novo bank's life cycle with the business cycle.

But, apart from these life-cycle effects, de novo banks and established banks tend to fail for similar reasons. Reckless financial practices such as aggressive lending, poor cost control or reliance on noncore deposits are associated with higher rates of failure for banks of all sizes.

Myth of a product and service gap

De novo banks are smaller than traditional lending institutions - but that doesn't mean they're at a disadvantage when it comes to offering the latest products and services.

For example, de novo banks are often early adopters of new, timesaving technologies. Consider systems that scan checks and deposit them into customer accounts electronically. Funds are disbursed to the correct account without the customer or even a paper check leaving the office - thus compensating for the lack of convenient branch locations big banks offer.

In the past, only bigger banks could afford to offer online banking and other high-tech services. But now so many systems can be outsourced that newer, smaller banks can match or even beat the systems offered by their regional and national rivals - and be first to introduce these systems to market.

Specialized focus

Though de novo banks may often best their larger rivals on some technology, they might not offer the same breadth and depth of services. If you work with a de novo bank, you might need to have more than one banking relationship. Many de novo banks specialize in certain types of lending. In Walker's Atlanta banking community, for example, most small banks are heavily and almost exclusively focused on real-estate-related transactions. Customers might need to go elsewhere for other products and services. But the benefits of this special focus might make it worthwhile to use a de novo bank.

"We focus on commercial and industrial clients, meaning we get into deep financial analysis," he says. "Most big banks would handle credit decisions for our clients on a centralized basis, using a credit-scoring model. We analyze a loan request the traditional way, spreading financial statements and working with the borrower to analyze projections."

What to look for in a de novo bank

Not all de novo banks operate similarly. Following are some rules of thumb when considering doing business with a bank start-up:

  • Work with a bank that's poised to grow as you grow. The typical de novo raises approximately $15 million in assets at launch. Make sure the bank has the capital to meet your needs.

  • Look for bankers who are knowledgeable about your type of business. They might be able to suggest a financial strategy you haven't considered. Often, bankers with specific industry experience offer their expertise without charging a premium.

  • Take advantage of the opportunity to nourish personal relationships. Deal directly with the bank president - the key decision-maker who could help your company on its path toward growth and stability. Look for de novo bankers you have worked with at other banks in the past, since they know your business and may be more likely to work with you again.