New regulatory pressures and slow economic growth have been taking their toll on the US's small regional lenders, leading to worries that many of them will be squeezed out of the market. But results from the first quarter of 2014 show that these smaller players are actually performing better than the country's larger lenders. 

Is an environment of low interest rates, slow economic growth, new financial regulations and pressing technological demands crushing the US's community banks, as the CEOs of some of these banks allege? Or is the outlook for the country’s 6234 community banks – with assets ranging from less than $100m to $10bn – much more nuanced?

Vindicating the latter view are results from the first quarter of 2014, published by the Federal Deposit Insurance Corporation (FDIC). These show that more than half of the US's community banks are more profitable than they were a year ago. There was an aggregate decline in profits of 1.5% compared with the first quarter 2013, but this is far less than the 7.6% profit drop that was seen across the entire US banking industry in the period.

Furthermore, community banks' net interest income, which accounts for, on average, 80% of their operating profits, saw larger year-on-year increases than at the country’s big banks. Similarly, year-on-year loan growth stood at 6.6% for community banks, almost double the US banking industry’s aggregate 3.6% increase. And, the non-current (or non-performing) loan rate at community banks, which at 1.68% stood at its lowest level since the first quarter 2008, was significantly less than the country's 2.46% average.

Community spirit

Richard Brown, FDIC’s chief economist, dismisses the claims made by one community bank CEO recently that post-crisis 'too big to fail' banks at the top of the industry have created 'too small to succeed' banks at the bottom of the pile. “It’s vastly over-stated," he says of the theory. “Community banks are actually doing very well. They’ve come through the crisis and are doing business with strong balance sheets... The idea that they are too small to succeed – the numbers simply don’t bear that out.”

Chris Courtney, CEO of Oak Valley Community Bank in Oakdale California, which has $687m of assets and 15 branches, also thinks the ‘too small to succeed’ notion is exaggerated. In the past 10 years, his bank has posted return-on-asset ratios that “beat almost anybody”, he says. Moreover, for the past two years it has made it onto the bank honour roll, a list of about 30 superior performers in the banking industry compiled by US financial analysts Keefe, Bruyette and Woods.

The resilience of small US banks – and the root of their success – says Mr Brown, is their community banking business model, which sees them providing traditional banking services to a local community, obtaining most deposits locally, making loans to local businesses and developing specialised knowledge of the local economy and customers. Because of this, community banks are often called ‘relationship' banks, as oppose to ‘transactional’ banks, which are large and focus on economies of scale in many areas of lending.

This marked difference between the two models has impacted the categories of loans that community banks have remained competitive in offering because, over the years, more and more consumer loans, from car loans and credit cards to personal loans, home equity and residential mortgages, have become standardised and taken over by bigger operators as well as, in recent years, internet banking.

“In the past, these consumer loans were more relationship driven. Now it’s transactional, very process driven... As people’s access to the internet – whether through their tablets, their desktops or their smartphones – has increased, these types of consumer banking services are very easy to access on the go,” says Lionel Castillo, president and CEO of American Bank of Commerce, a community bank based in the Provo, in the Salt Lake City area of Utah, which has $75m in assets and three branches.

“It’s a good solution for customers," he says. "But it’s a challenge for us.”

Technologically challenged

On the other hand, community banks' small loans to businesses – typically loans to commercial borrowers of up to $1m and farm loans of up to $500,000, according to the FDIC – continue to be based on local knowledge and non-standardised data obtained through long-standing connections. This is the opposite of the models-based underwriting used by large banks.

Small business lending has remained a consistent niche of community banks. In the first quarter of 2014, community banks had assets totalling $2000bn, just 14% of the US banking system’s total, but they accounted for 45% of the industry’s small business loans.

Moreover, as big banks have been introducing digital services to expand their small business lending, community banks have been following suit, adding features to their online and mobile banking offerings that allow business clients to better distribute invoices, more quickly approve wire transfers, deposit cheques and manage other day-to-day tasks that may previously have required going into a branch.

“Anything a big bank can deliver on the technology side, we have third-party vendors that allow us to do that and cost effectively,” says Mr Courtney.

Worlds apart

Community banks are also important to the national economy, because in thousands of rural communities, small towns and urban neighbourhoods, which are frequently overlooked by larger banks, it is community banks that provide mainstream banking services. “There are communities all over Kansas and Nebraska where community banks are the only banks that exist. In some instances there may not be a post office nearby but you’ll have a community bank," says Chris Cole, senior vice-president of the Independent Community Bankers Association.

Lending habits and geographic location continue to play an important part in community banks' fortunes, though not as decisively as during the 2008 crisis, FDIC officials say. During this time, the highest community bank failure rates were seen among banks with high concentrations of commercial real estate, and land acquisition, development and construction loans, as well as banks in states with big housing booms and busts, particularly those in the south-west, south-east and upper mid-west of the country.

Conversely, small banks tended to do well, and continue to do so now, especially when they either specialise in agricultural lending or are located in areas where energy and agricultural production predominate.

Supersize me

Consolidation has been dramatic, at both ends of the US banking industry. The number of institutions with assets of less than $25m declined by 96% from 5717 to just 205 between 1985 and the end of 2013, while the size and share of industry assets held by banks with assets greater than $10bn grew from $110bn – 28% of the system’s total – to $11900bn – 81% of industry’s assets, an FDIC study shows. 

Amid this consolidation, banks in the middle, with assets of between $100m and $10bn, were relatively stable and grew moderately, as did the number of these banks.

At present, mergers are mainly between community banks. There could be “about 180 to 200” such mergers this year, but that still only affects less than 5% of all community banks, says Mr Cole. Factors often cited by community bankers as reasons for a merger are: adjustments to, and the costs, of new regulations; a bank’s asset size; and the economic situation.

Dan Baird, CEO of Capital Funding Group Community Bank in Maryland, explains how the sale of his bank to West Virginia-based MVB Bank was spurred by new capital requirements in Basel III. These will start to take effect on community banks on January 1, 2015, and include a long phasing-in period up to January 1, 2019. The trouble, says Mr Baird, is that the new Basel regulations impose strict limits on the amount of mortgage-servicing rights banks can count as Tier 1 capital.

"But our mortgage servicing rights are a significant portion of our capital. We saw a situation where we would be under-capitalised down the road. So we sold the bank,” he says.

For another community banker, Peter Alworth, chairman of the Minneapolis-based Great Northern Bank, which has $71.2m in assets, it was the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and subsequent Consumer Financial Protection Bureau mortgage rules, that took effect in January 2014, which were instrumental in his decision this year to merge with First America Bank, which has $93.4m of assets and is based in western Wisconsin.

“If we didn’t end up merging we would probably have to add one more person to do regulatory compliance work, which for a staff of 25 could represent more than a 5% payroll increase," he says.

Regulatory worries

Mr Courtney – whose Californian bank specialises in establishing what he calls a "full relationship" with a gamut of small businesses, providing loans and services and also taking the business staff’s deposits – says his compliance department has not grown in seven years. “I always scratch my head at this talk about compliance costs. I see it as a competency issue. We have a very strong crew,” he says.

Some analysts say that recent reaction from some small banks and lobbyists against the new regulations is misleading. The new rules are overwhelmingly focused on consumer and mortgage underwriting and lending, so community banks that concentrate on small business lending should feel little impact.

It is also the case that regulators have started to soften their approach towards these types of institution. For instance, more types of mortgages originated and/or serviced by community banks now benefit from the safe harbour, or best practice, 'qualified mortgage' rule, which provides lenders with the most protection from legal liability and requires that borrowers have a debt-to-income ratio no greater than 43%.

Meanwhile, Wesley Sturges, CEO of the $129m Bank of Commerce, primarily a small business lender from Charlotte, North Carolina, says scale was a factor in his decision to sell the bank to North Carolina-based HomeTrust Bancshares in a cash and stock deal worth more than $13m.    

On the acquisition side, Dana Stonestreet, chairman, president and CEO of HomeTrust Bancshares, says that when a decision was made to convert HomeTrust to a stock form of ownership in July 2012, this provided additional capital and “the goal was to put that capital to work to buy other community banks”. This would increase the asset base of the bank so that it was in a stronger position to leverage costs and this would allow it to access “larger markets with opportunities for future growth”.

Subsequently, Mr Stonestreet acquired three small banks in slightly over one year, one in Greenville, a burgeoning town a short distance away in South Carolina, another across North Carolina’s western border in Tennessee, and Bank of Commerce. When all three mergers are completed HomeTrust is expected to have $2.2bn in assets and $1.7bn in deposits.

Organic growth

Mergers and acquisitions are not the only route to growth for the US's small banks, however. Tom Bennett, CEO of Oklahoma-based First Oklahoma Bank, says that his bank succeeded in growing from just $9.6m in assets in 2009 to $296m at the end of March 2014. This, he says, was down to the strength of the local agricultural and energy-producing economy, “which didn’t experience the recession as harshly as other parts of the country and recovered more quickly”.

The bank's success was also helped by the fact that four local banks, which Mr Bennett describes as “major competitors”, were sold in the past two years. This had the effect of disrupting relationships which creates opportunities, according to Mr Bennett.

“Growth is easiest to achieve when there are new things happening in a community, when businesses are just starting or businesses are expanding. Both are happening in Tulsa,” he says.

Meanwhile, Mr Courtney says that the growth strategy that Oak Valley Community Bank has been following for the past 23 years is based on building the bank one branch at a time. Oak Valley has set the goal of eventually having $1bn in assets and 20 to 25 branches.

While not ruling out the possibility of a merger in future, Mr Courtney says that such a strategy “involves a lot of risk. You have different people, different cultures. You can’t really do things the way you want to. The majority of mergers don’t work.”

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