We have previously discussed at length the changes taking place in the competitive environment of the banking industry—the challenges facing the major banks as they continue to grapple with regulatory deposit caps, the cut-throat competition for both loans and deposits among the regional banks, and the emergence of the mega-community banks as a competitive force to be reckoned with in coming years. But absent in our discussion—or any other discussion that we have seen recently—is any serious consideration of the fate of the true community banks, those FDIC-insured institutions (both banks and thrifts, for our purposes) under $1 billion in size. What exactly happens to these companies, which actually constitute (by number) the largest segment of the American banking industry?
First, let us size the issue. According to the latest FDIC Quarterly Profile (4Q17), there are 5,670 FDIC-insured banks and thrifts in the U.S., of which 4,920 (87 percent, roughly) have less than $1 billion in assets. (Click here to view chart 1.) Indeed, 25 percent of American banks have less than $100 million in assets, with the remaining 62 percent having balance sheets between $100 million and $1 billion in size. From an overall balance sheet standpoint, these smaller community banks have about 7 percent of total U.S. banking assets and 8 percent of deposits, and enjoy stronger net interest margins than the industry as a whole—3.74 percent and 3.79 percent respectively for the two size segments, versus 3.31 percent for the American banking industry overall. (Click here to view chart 2.)
Those are the numbers, but frankly they don’t tell much of the story of the smaller community banks. As we have traveled throughout the southeast, we have encountered the managements of many of these companies, and listened to many of the stories of their everyday existence. And we have found that there is no one over-arching narrative—many are beset by fierce competitive forces, all are coping with a regulatory landscape that is seen to be largely indifferent to the cost burden of banking regulation, and all are struggling to stay relevant in a time of both rapid demographic and technological change. At the same time, these smaller community banks are ever more important to the small (and often rural) communities where they are headquartered, as they are increasingly the only local financial institution willing to provide credit and payment services for small businesses and high-touch service for their depositors.
Wall Street and banking industry “experts” seem to have consigned these smaller banks to irrelevance, due primarily to the issues of size and scale, and the dominant thinking is that any bank under $1 billion in assets is doomed to industry irrelevance and to eventual extinction. We think that the prediction of such a fate is premature and supposes a uniformity among these banks that does not reflect the reality on the ground. Many of these banks have been in existence for decades, are not public companies and/or have a shareholder base that is limited to a few local families, and do not have the same requirements for returns to shareholders that larger banks, with their more diverse shareholder bases, may have.
At the same time, many small community banks have challenges that are unique to their size and history. The bulk of discussions that we have had with small community bank CEOs involve “monetizing” the value of their holdings and finalizing clear succession plans for their banks. To the dismay of many, their children are often no longer interested in entering the banking industry—even though their paths to the top of these banks may be clear—and many are not interested in continuing to live in these smaller towns. And it’s a pretty well accepted fact that the average age of community bank CEOs is rapidly climbing (it’s 58 years for the industry as a whole), making these decisions about liquidity and succession ever more urgent. (Click here for chart 3).
There is, of course, the option for a merger with another bank that is facing similar challenges, but our experience has been that these “mergers of equals” (MOE) get sticky, and usually do so pretty quickly. The decisions about management structure are difficult and often stop deals that would be otherwise beneficial for both companies, as do the fears about the impact on the local communities and the possible loss of jobs as expense savings are realized.
The model for success in an MOE remains one that occurred in the larger community banking sphere in 1994—the merger of Branch Banking & Trust with Southern National—and it’s now interesting to remember that the combination of these two North Carolina franchises resulted in a then-behemoth with $18 billion in assets, 535 branches (70 of which were eventually closed) and a deal value of $2.2 billion. The merger was seen as revolutionary at the time, and the secret of its success—the CEO of Southern National, Glenn Orr, was paid $20 million-plus to essentially go away—caused great consternation in the community and among shareholders. But John Allison, who took the helm of the new company, always said that it was the best $20 million he ever spent, and the result has been banking history. (Click here for chart 4.)
We know that most community bankers do not have millions of dollars to throw around on CEO severance packages, but we do believe that MOEs will nonetheless have to make a reappearance as a community bank survival strategy, especially for those smaller companies with overlapping or adjacent operating geographies. While succession and liquidity are important for those CEOs ready to retire, the fact remains that no community banker—regardless of age or bank size—can afford to ignore the realities of changing demographics (the coming dominance of the Millennials and their eclectic consumer preferences) and the ever-growing need to provide a broader suite of mobile and digital products for customers of all types and all ages.
Can small community banks continue to exist in the future? They most certainly can, and they will—and profitability and the ability to deliver acceptable returns to their shareholders and satisfaction to their customers will be the key. The fact that the number of community banks with assets under $10 billion has fallen from 8,263 at the beginning of 2000 to 5,547 presently—down 33 percent —is due to a number of factors, among them the ongoing impacts of the Financial Crisis, the burdensome costs of Dodd-Frank regulation, the impacts of fintech, and the failure to resolve the organic issues of scale. There is no one factor that has accelerated this reality of asset and deposit concentration in the banking industry, and there will be no “magic bullet” (including the deregulatory bent of the Trump Administration) that will make it all go away.
Will the number of community banks in the U.S. continue to decline? Almost certainly. There will be another economic recession in the not-too-distant future, and this downturn will almost certainly take out those small banks that have failed to fully resolve their issues of concentration and lack of asset diversification that have lingered from the last crisis. But our hope—and our wish—is that the number of banks will decline because community bankers have chosen to be proactive, to seek partnerships that make sense, to overcome the sometimes parochial issues that stand in the way of smart business decisions, and to become lean and mean in a way that has historically not always been the case in this important segment of the banking industry.
Click here to read NAB Research’s disclosures for the preceding commentary.
This commentary was provided by Nancy A. Bush, CFA of NAB Research, LLC and is being distributed by Banks Street Partners, LLC. The views of the author do not necessarily represent the view of Banks Street, and Banks Street has neither directed nor had editorial oversight over the content. Material in this report is from sources believed to be reliable but no attempt has been made to verify its accuracy. Past performance is no guarantee of future results. Banks Street Partners actively seeks to conduct investment banking in the financial institutions and services sector, including with the companies listed in this report. To learn more about Banks Street Partners, please visit www.BanksStreetPartners.com.
