The way forward in 2014

Strategic opportunities for'tommunity Brinks

We hear a lot about how much the banking industry is changing. Some experts even believe that community banks will be driven to extinction by the forces of change that have been let loose in the marketplace. But community bankers have been hearing similar predictions for decades. The relatively slow historical rate of consolidation in the banking industry has always confounded the experts.

Community banks have shown more resilience than many expected. They have long been able to exploit niches in the markets that remain untouched or underserved by larger predators. This basic operational strategy has not necessarily been invalidated by recent changes in economic and market conditions. Some of these changes may even have given community banking a new lease on life.

However, the conventional wisdom appears to be correct in judging that the forces of market change will likely be both significant and long lasting in their impact upon community banking in America. The community banking industry's market share has been steadily shrinking for years due to increasing inroads made by both large banks and non-banking competitors into markets traditionally served by smaller community banks. The consensus seems to be that this trend will likely continue and even accelerate.

While the conventional wisdom can sometimes be wrong about timing, it is usually correct about long-term consequences. Moreover, useful guidance for community bankers can be extracted from the swirl of ideas and strategies being offered to community bankers by industry analysts and commentators and successful bankers.

The old community bank model

Most successful bankers today will agree that optimism about the future must be tempered by the realization that old-style community banking will become increasingly threatened.

Banks at greatest risk are the ones that have survived so far only because they have little competition in their local markets and enjoy easy access to low-cost deposits. These banks typically have little loan demand and little management capability to generate loans even if the demand exists. They often have excess capital and complacent shareholders who may even have accepted management's perspective that return on assets and not return on equity is the most important measure of bank performance.

Such complacency is a legacy of times when community banks were effectively protected by law, enjoying a government-granted monopoly and often benefiting from unit banking restrictions that prevented concentration of bank ownership. Those legal advantages are gone now. Indeed, the privilege of owning a bank has become a burden in some respects, due to both regulatory and economic constraints, and especially because of the cost of deposit insurance and regulator-imposed capital requirements in excess of levels permitted for nonbank competitors.

The chickens come home to roost

Some community bankers agree with this assessment but still have reason to doubt predictions that the future will be substantially different or worse than the past. Thirty years ago, they were warned that the imminent arrival of the "check-less" society would render obsolete those core services that, then as now, sustain most community banks - managing deposit accounts and check processing.

The fact that this particular revolution has taken a while to arrive does not mean that it is not finally coming. Moreover, it seems to be arriving at a time when banks can also expect lower profits from overdrafts and corporate checking and greater constraints on interchange fees, all of which constitute a sort of perfect storm of adverse effects upon traditional sources of income for smaller banks.

The baseline trend is inescapable. Especially as long as interest rates remain low, smaller banks will have more difficulty than larger banks in offsetting low interest income with increased fee income. At present, the largest banks in the nation already enjoy more than a 1 percent higher profit margin than smaller banks, with the difference being mainly attributable to differences in total fee or noninterest income.

This is one reason among many why the big banks are competing more effectively than small banks in today's market. And if new commercial banks are not being minted (as they currently are not), this imbalance will inevitably hasten the decline of community bank numbers and market share.

Confronting change

The new challenges facing community banks are substantial, buMjbey are not insurmountable. Once again, appreciating the market reality of those challenges is the first step towards developing strategic understanding and towards finding the path forward that makes sense for a particular bank.

The market reality is that most community banks will no longer enjoy protected markets because every product or service the bank can offer is also being offered (through every technological medium possible) by larger banks, brokerage firms, credit unions, thrifts as well as nonbank companies of various kinds.

The banking industry has become the financial services industry, and with this transition has come a new emphasis on economies of scale, product diversification, technological sophistication, wireless networking and many other innovations that smaller community banks will be hard-pressed to accommodate.

Those realities are threats to business-as-usual, not necessarily threats to bank survival. Opportunities may yet abound. There are still interstices in the marketplace - comer pockets, market niches - where a strategy of providing more targeted and more flexible products and services, delivered with superior personal service, can succeed better for nimble community banks than for the largest banks.

Or so the argument goes. But does it hold up?

Adapting to change

Two broad strategies seem to be available for providers of financial services - product differentiation or overall cost leadership. The larger banks are mainly striving to become low-cost producers of commodity-like products, such as credit cards, checking and savings accounts, consumer loans, mortgage loans and so forth.

These banks are struggling to achieve critical mass and harness emerging new technologies to create economies of scale as well as size-related market power. Other larger banks have selected a differentiation or focus strategy by choosing one particular industry niche, such as trust services or investment banking, upon which to concentrate available management talent and capital resources.

In this context, community banking can be viewed as just another niche-type of market that can be concentrated upon and developed as assiduously as the larger banks might pursue one of the commodity segments of the market.

Past experience suggests that there will always be markets for certain kinds of specialized or personalized services in banking that cannot readily be provided through large, centralized corporate structures. Some kinds of loans cannot be made solely on the basis of an objective credit-scoring system; certain customers will sacrifice all considerations of cost for personal service and access to senior management.

As consolidation in the banking industry continues, it may even be that greater, not less, opportunity will await smaller banking organizations that can effectively deliver the responsiveness and personal service that these market segments demand.

Of course, this formula for success is not new. Many community banks have already adopted strategic plans that embody some version of the foregoing goals. But something needs to change because the banking industry itself has undergone a sea change of sorts.

Going forward, the new models for successful community banking must be different, or at least more refined, from those of the past because the baseline economic and operational assumptions underlying the community bank business model have changed too much for progress forward to be possible any other way.

Size matters

In the banking industry, as in business generally, achieving economies of scale is a powerful argument for increasing size. Large firms can produce more revenue and support more assets without necessarily incurring proportionate increases in expense and personnel base. In addition, historically low interest rates, increasing costs of compliance and limited access to capital and liquidity are all contributing to the pervasive mentality that bigger is better.

These assumptions are compelling, but economies of scale for banks do not necessarily continue to improve in a linear fashion as bank size increases. The point on the scale where economies are utilized efficiently will vary greatly depending upon the type of business the bank conducts. Vast size is obviously critical to becoming the low-cost producer in market segments based upon commodity-like products.

Size may be less important when the bank is pursuing a particular market niche, but even then some minimum size is required just to put forward the chosen array of products and services and to cope with the regulatory burden that attends engaging in any form of the banking business.

A bank that wishes to focus generally on the community banking niche must still be large enough to be efficient in offering a basic assortment of deposit, investment and loan products and services, even if some of those capabilities are leased from third-party vendors.

Achieving certain size and scale improves access to vendor platforms and negotiating leverage and, more importantly, allows the cost of innovation in services and complying with new regulations to be spread across a larger asset base. Greater efficiency is ultimately the main thing that big banks have over small banks. The closer smaller banks can emulate their example, the better off they are likely to be.

Finally, bigger banks are simply worth more than smaller banks when it comes to selling them. Bigger bites will be more attractive to potential buyers than smaller bites, for the simple reason that the buyer banks are likely to be public companies, for which growth is definitely a virtue.

Focus matters

Effectively managing the liability side of the balance sheet will continue to be especially important for community banks because that is where insured banks generally enjoy a market advantage. However, the opportunity for focus and customizing a bank to a particular market niche comes more from how the asset side of the balance sheet is administered.

Specialization may be the key. Smaller banks will find ways to reach beyond local markets in some lending categories, including mortgage loan origination, SBA lending, FHA-guaranteed agricultural lending, specialized consumer product finance programs and whatever else market demand, ingenuity and available capital and managerial resources may allow.

If there is not much local loan demand of any kind, which will be the case for many rural banks, it will become all the more important that the bank's investment portfolio administration functions at top efficiency and under the control of appropriate policies and best practices, again with independent outside adviser help as necessary.

Achieving balance: Optimizing franchise potential

The challenge comes in fine-tuning the balance of focus and activity to fit the realities of the bank's particular market, giving due regard to management expertise, capital resources and market opportunity.

The fact that some customers may be willing to sacrifice considerations of cost and product diversity for personal service gets you only so far. There will always be competitors who can both deliver sophisticated products and a high level of personal service.

Something more will be required. Having a particularly well-informed and articulated strategic plan of attack will be vital, particularly if the plan helps focus the bank upon a particular market strategy that optimizes the bank's key resources - location, management and capital.

Strategic affiliations with good technology partners and advisers will also be important. Fortunately, the progress of technology has so far blessed community banking in one important respect. It enables smaller banks to offer and administer sophisticated products with seamless marketing and back office support provided by third-party vendors.

These arrangements will continue to play an important role in helping community banks offer sophisticated products and services that are competitive with the best that the largest banks can offer.

Evolving paradigms in community banking

These observations suggest that the successful community bank of tomorrow will be different from the typical community bank of today in important ways.

One difference will be one of degree. Most surviving community banks will be larger. The traditional model of the small, locally owned independent bank is inherently unstable in today's environment. These banks will simply lack the economic critical mass to play the new hand they have been dealt by market and regulatory circumstances.

At the same time, one of the traditional strengths of community banks, local ownership and control, can also become a material weakness for some banks in an era where capital is still king. The pool of local capital available to support growth is limited, which results over time in exactly the consequence that the managers of these banks fear the most, loss of independence.

Rethinking Subchapter S

Subchapter S has provided a tax haven of sorts for many community banks in recent years. About one-third of all community banks operate as Sub S banks, which under current tax law may not have more than one class of outstanding stock and not more than 100 individual shareholders, counting family members as one but excluding shareholders like private equity investors, who typically operate through entities that are not eligible shareholders.

Legislative proposals may ease these restrictions to allow greater access to capital, but the fact remains that Subchapter S was designed for "small" businesses that have relatively low growth and less need for capital retention and that can thus afford to pass through a substantial portion of current earnings to shareholders.

A bank that needs to retain most of its earnings to support capital will not receive much tax benefit from the Subchapter S structure and may be better off shedding the constraints on access to new capital that come with the structure.

Shareholder liquidity

Given market pressures and the need for shareholder liquidity, community banks of the future will not only be bigger in asset size and capital base, but, increasingly, they will also need to become public companies and maintain active trading markets for their stock. The key to preserving independence is maintaining liquidity for shareholders. When shareholders cannot readily sell their stock, pressure will inevitably build to sell the bank.

Smaller banks can typically use holding companies or other internal means to manage liquidity. But as the capital base grows, the numbers involved become correspondingly larger, especially as one considers the fate of larger shareholders.

At some point, providing liquidity for major shareholders often becomes possible only by selling the entire bank. This inescapable fact will provide the fundamental driver for continued consolidation among community banks.

Consolidation is inevitable: Live with it

Over time, whether because of capital needs or liquidity pressure, smaller community banks will inevitably be consolidated through acquisitions and mergers of equals to evolve into so-called super-community banks or larger regional banks, most of which will be publicly traded.

Banks that avoid being swept up in these amalgamations will be able to do so only because they find themselves off the beaten path of competition or because they have found some particular market niche (within the broader niche that is community banking) where size and economies of scale are less important.

In either case, there will very likely be many viable pathways forward for community banks. Next month's article looks in greater detail at where some of those paths might lead. $

Joe Ford has practiced law in Texas since graduating from Harvard Law School in 1970. His career serving community banks has focused mainly on ownership matters and capital financing. He is associated with Fenimore. Kay. Harrison Ford, LLP, and the Bank Strategy Institute. both in Austin. He will welcome your comments at [email protected]. This isptart one of a two-part article.