In this issue of The Institutional Risk Analyst, we speak to John A. Kanas, Chairman of BankUnited (NYSE:BKU). Kanas rose to prominence in the banking world first by building North Fork Bank into a leading northeast community lender, then selling it in 2006 to CapitalOne Financial (NYSE:COF) for $14 billion in cash and stock. In 2009, he led an investor group, which included Blackstone, Carlyle Group, Centerbridge Partners and WL Ross & Co, that acquired a failed Florida thrift called BankUnited. Kanas and his veteran team rebuilt the bank and doubled the institution’s assets over the past seven years. He stepped down as CEO of BankUnited in January, handing the reins over to COO Rajinder P. Singh. We spoke to him last week from Florida.

RCW: John, thanks for taking time to speak with us. When you look back over building North Fork and BankUnited, two very different banks, how do you think about these two institutions?

JK: Building North Fork really was about the banking market of the 1990s and 2000s. BankUnited was a failed bank that we acquired from the FDIC in 2009. Both banks were similar in that they served a local community of businesses and consumers, classic relationship banking. You had to understand the local landscape and give your customers white glove service. As today, the competition for deposits and loans in those days was intense.

RCW: Is there more competition today in the industry among smaller banks than the larger institutions?

JK: Competition among smaller institutions has always been intense. The larger banks have very different funding models. The smaller banks are going head-to-head for the best customers in the markets they serve. The larger banks really don’t focus on those types of customers, small to mid-size businesses, for example.

RCW: And the larger banks tend to be half market funded as opposed to core deposits. It sounds like the smaller banks need the deposits. Is that good?

JK: Yes, there is clearly an ongoing need for deposit growth at banks. Mid-cap and smaller banks tend to be fully loaned out with ratios of loans to deposits in the 90 percent range vs. the 70s years ago.

RCW: The data from the FDIC suggests that, over the past 30 to 40 years, banks have seen the average return on earning assets fall from over 1% to just 75bp today. Has this shrinkage in asset returns forced banks to increase their leverage by making more loans?

JK: In part that is definitely true. Remember that we have been operating in a period of declining interest rates for decades, so banks have been forced to adjust their business models to support returns.

RCW: Your peers among the better run community banks tend to have loan to deposit rations in the 90 percent range, yet the old models used by bank regulators and rating agencies penalized banks for being fully loaned out. Does the credit sector need to rethink how they assess loan to deposit ratios and bank business models?

JK: That is correct. In today’s market, a well-run institution has to be fully loaned out to make the asset and equity returns work.

RCW: Does the question of success or failure for a bank ultimately come down to credit management? Look at Bank of the Ozarks (NASDAQ:OZRK). We get calls constantly from investors looking to short that stock because of the focus on C&I lending and commercial real estate. Our response is “be careful what you wish for.” Bank of the Ozarks has a very strong credit culture and went through the financial crisis pretty much unscathed. In fact, our friends at Kroll Bond Ratings just put OZRK on watch for a ratings upgrade!

JK: A lot of people have lost a great deal of money trying to short OZRK over the past several years. The bank has performed extremely well despite their focus on real estate lending.

RCW: At BankUnited, you tended to stay away from areas such as residential mortgages and auto loans, preferring to focus on commercial lending. Has this included lending on construction and development in your footprints in New York and Florida? The banking industry’s portfolio numbers on C&D lending are literally half of where they were before 2008, largely because the loans were charged off and restructured. A number of banks failed because of C&D. How do you view the C&D sector given your focus on FL and NY?

JK: The regulators have been very direct with their guidance to the industry regarding C&D lending because of the experience that you mentioned. It has been very tough to expand that asset class. The message from regulators is that C&D lending must be done very carefully.

RCW: The number of home builders have been cut by a third since 2008. It is not hard to understand the concerns of regulators given the number of bank failures. How does the US grow the amount of credit available to support new construction of single family homes? The asset prices for residential properties in your footprint have been soaring and the credit metrics for defaulted construction loans are extremely good.

JK: C&D loans today tend to be 30-40 percent loan to cost as most, meaning that there is a lot of equity in these deals. The regulators have a very cautious posture toward construction lending and this is reflected in LTV ratios. Yet if I were running my own bank today, without being accountable to other shareholders or regulators, I would do nothing but construction lending because there is such a great need.

RCW: And better returns than residential mortgages or prime auto loans. Let’s go back to BankUnited transaction for a moment. When you acquired that bank from the FDIC, what was different about that experience vs building North Fork?

JK: When we bought BankUnited in May of 2009, we were one of less than five bids for the bank. I was working with Wilbur Ross at the time to identify opportunities in the banking sector. The situation in the markets was very uncertain. Nobody in the financial world had a clear vision about what to do next. The prices for failed bank assets reflected this uncertainty. North Fork was a much more conventional story having been forged out of 18 acquisitions over 30 years.

RCW: When then-FDIC Chairman Sheila Bair and her colleagues at the FDIC sold Indymac in January 2009, the literally room was empty. The FDIC put loss-sharing on the table and got the party started, but it sounds like not much changed in several months between that transaction and the acquisition of BankUnited.

JK: The pricing did not change immediately. Our original plan going into the BankUnited transaction was to buy a number of failed banks in Florida but once we closed the acquisition, the pricing in the market improved dramatically for the FDIC. That ultimately drove our decision not to continue with a more aggressive acquisition plan.

RCW: So how about today? The whole industry was taken up by 20-30% following the election of Donald Trump. What do you tell your shareholders about the movement in banks stocks over the past six months?

JK: There was a lot of enthusiasm after the election given the prospect for tax cuts and deregulation, but this promise has faded. It is not clear what will actually be changed in terms of the regulatory environment this year.

RCW: It looks like the regulatory relief for small banks will be the easiest thing to get through the Congress. Do you agree with that?

JK: Yes, there is clearly support for regulatory changes to help small banks. The support for rest of the agenda is far less clear, including tax cuts and other changes outside of the regulatory sphere. The community bank sector is very competitive right now when it comes to deposits particularly. There is a case to be made that smaller banks need relief so that they can continue to provide credit to local customers.

RCW: So talk about the community banking sector going forward. There is a flood of opinion coming from the investment bankers and consultants that says that community banks are doomed and the industry will consolidate down to 1,000 banks. Is that your view?

JK: I can remember first hearing those arguments about the demise of community banking back in the 1970s. Community banks are more relevant today than ever. So long as you have small communities with local businesses that need to be financed, community banks will be the only option to support this part of the American economy.

RCW: Former Fed Chairman Paul Volcker reportedly once said that the only innovation in banking has been the ATM machine. Is that true? Is the industry changing of its own volition or is change being imposed?

JK: Technology is clearly changing the industry in a number of ways, but there are also cases where the local demand for services actually goes the other way. We had looked at closing some branches in FL, for example, but when some of our competition shuttered branches, we found that our business grew at our facilities. The fact is that when people enter into a significant transaction like a business loan or home purchase, they want to talk to someone face-to-face.

RCW: There is a lot of talk about how technology is pushing the industry towards branchless banking, yet the statistics seem to suggest that while consumer like to shop online, they also like to sit across the table from a banker when they enter into a major transaction like buying a home. And bankers often like to have a look at a prospective customer before committing on a loan.

JK: Correct. When consumers or small business people enter into a significant commitment, they frequently want to do it in person. Going back to my earlier comment about “white glove” service, community banking is about individual service above all else. In the competitive environment in the industry today, you must be as aware of your customers’ needs as you are about new technology.

RCW: We are part of a debate in the financial economics community about whether the fact of the Fed paying interest on excess reserves negatively impacts lending. Given the competitive environment you described, do you think that the fact of the Fed offering 1% risk free on excess reserves impacts your calculus as a lender, either in terms of price or the actual decision to lend? Net of FDIC deposit premiums, you’re making 85 to 90bps.

JK: Any time risk-free investments are available to banks they present competition to building loan assets. Interest on reserves at the 1% level is no exception.

RCW: We hear periodic rumors about you possibly going to Washington. The Wall Street Journal had a comment earlier this year. Is there any truth to these reports?

JK: I have had some discussions with the Administration about a number of possibilities. There are some very capable people being considered for positions in the bank regulatory world but the process is ongoing. There are something like 150 individuals being considered for the positions that require confirmation alone. I don’t have any specific plans at the moment. I have a two year commitment as Chairman of BankUnited and look forward to being helpful to the industry as opportunities arise.

RCW: Thanks for your time John.