More community banks join OTC exchange to raise profile with investors

More community banks have begun trading via over-the-counter markets, hoping to capitalize on a stock rally fueled in part by a brightening outlook for small lenders.

With pent-up economic demand driving consumer spending and business expansions, investors expect loan demand to follow in the second half of this year and into 2022. As inflationary pressures build, so too does the likelihood of higher interest rates. And when rates rise, banks earn more interest income on new loans.

S&P Global’s small-cap bank index is up about 60% over the past 12 months. Against that backdrop, OTC Markets Group, a low-cost alternative to national stock exchanges, said its OTCQX marketplace gained 10 new banks in the first half of 2021 — more than in the entirety of 2020 year and putting growth back on par with pre-pandemic levels in 2019. OTCQX, the highest level of over-the-counter trading, was home to 100 banks in June, a record number for the trading system since it opened to banks in 2014.

“There’s a great deal of optimism” among listed banks, said Laura Hamilton, vice president of corporate services at OTC Markets.

She noted that community banks last year were distracted by Paycheck Protection Program lending and other efforts to navigate the pandemic. That put investor relations work on ice. Of course, bank stocks also took a beating early in 2020 amid fears that coronavirus outbreaks would thrust the U.S. economy into a prolonged recession and drive up banks’ loan losses. That made it difficult to pursue new investors.

But the industry’s worst fears about recession and loan losses never developed. Government stimulus programs, and an eventual rebound in economic activity kept businesses away from the brink.

“Clearly, we came out on the back end much better than anybody thought,” said Jason Paltrowitz, executive vice president of corporate services at OTC Markets Group.

Rates are still low, pressuring banks’ net interest margins, and loan demand is only beginning to climb, Paltrowitz said. But with momentum building in 2021 and robust economic growth projected — the Atlanta Fed estimates second-quarter gross domestic product expansion of 8% — investors are upbeat on bank stocks, he said.

The $1.5 billion-asset Santa Cruz County Bank joined OTCQX in May to gain more liquidity in its stock for existing shareholders and to grow its overall shareholder base, said Krista Snelling, the California bank’s president and CEO. The bank picked up more than $300 million in assets with its 2019 acquisition of Santa Cruz-based Lighthouse Bank, and is poised for strong post-pandemic growth, she said.

It is time, she said, for more investors to take notice now that the bank has moved up from a lower OTC tier.

“As we increase in size and sophistication, we want to grow our shareholder base as well,” Snelling said. “It’s a logical progression.”

She expects more banks to follow suit, should earnings grow alongside an expanding economy and should M&A return to pre-pandemic levels, as many expect it will. This trend would create more banks with over $1 billion of assets; the average asset size of an OTCQX bank is $1.2 billion.

Smaller banks may favor OTCQX listing because the market’s reporting requirements are less burdensome than national exchanges, but are transparent enough to make those banks appealing to investors.

Banks that trade on OTCQX do not have to meet Securities and Exchange Commission reporting requirements – a sizable cost burden. They instead agree to regularly organize and disseminate the detailed financial information they already compile to meet regulatory requirements.

Many small banks do not consistently make this information readily available in the form of press releases and annual reports. Investor attention, by extension, is often difficult to attract. By listing on the OTCQX, banks are required to regularly disclose material events in a consistent way that is intended to make information easily digestible for investors.

What’s more, by working with the OTC, banks on the OTCQX pay a $23,000 annual listing fee and in exchange they are assigned corporate brokers who provide advice on disclosing key financial information and help connect banks’ management teams with investors. If banks were to list on a national exchange, it could cost hundreds of thousands of dollars annually due to SEC compliance expenses and added investor relations staffing.

Over-the-counter platforms, while often well-organized, do not present many of the advantages of major exchanges, according to the International Monetary Fund. Over-the-counter networks consist of trading relationships centered around dealers that act as market makers by quoting prices at which they will sell to — or buy from — other dealers and to customers.

“That does not mean they quote the same prices to other dealers as they post to customers, and they do not necessarily quote the same prices to all customers,” according to an IMF report. “Exchanges are far more liquid because all buy and sell orders, as well as execution prices, are exposed to one another.”

Nevertheless, the OTC’s Paltrowitz said over-the-counter options are often the most viable for small banks with limited budgets to access trading liquidity. They also can be an option for privately held companies to become listed banks.

Paltrowitz noted, too, that about 80 banks were dropped from the Russell 3000 Index in June as part of its annual rebalancing. That’s more than in any year since the start of the Great Recession.

The cutoff for Russell inclusion this year was a market capitalization of nearly $260 million — far higher than any year since 2007, according to Janney data. The higher cutoff benefited companies in industries that rebounded from the pandemic quickly, and hurt those such as banks that have recovered only more recently.

Investors in index funds that replicate the Russell typically sell off companies that leave the index and buy those that move in. For those pushed out of the Russell, trading volume often declines, making it more difficult for investors to move in and out of the stock. Paltrowitz said some banks are likely to unload the higher cost of a national exchange when it is not accompanied by Russell inclusion, and list instead on the OTC markets.

“If you aren’t included in the Russell, you could essentially be a small fish in a big pond,” he said. “With OTC, you could be a big fish in a small pond.”

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