Magazine article The Journal of Lending & Credit Risk Management

Not Dead ... Yet

Magazine article The Journal of Lending & Credit Risk Management

Not Dead ... Yet

Article excerpt

"The reports of my death are greatly exaggerated."

- Mark Twain

Like Mark Twain, the predictions that community banks will disappear quickly also are exaggerated. But community banks will pass from the scene if they continue to operate in their traditional mode. Yes, there will be fewer community banks as we know them today, but there is ample time for most to transform themselves into new formats that deliver what the customers want and that can compete profitably with even the largest financial organizations.

Right now, it is very difficult to sell the predictions of inevitable decline and the need for transformation; community banks are, after all, surviving, if not exactly thriving. But both the signs of decline and the seeds for success are visible in current community bank performance, and particularly obvious when one looks at the best performers.

1. In general, return on equity for all community banks has been stable or declining for the past five years. The top-performing community banks, however, have continued to achieve superior performance [ILLUSTRATION FOR FIGURE 1 OMITTED].

2. While the entire community banking industry has made substantial gains in expanding noninterest income, the top performers have improved noninterest income to a level that truly remodels their earnings formulas and makes them better able to compete in the years ahead [ILLUSTRATION FOR FIGURE 2 OMITTED].

3. As a whole, community banks have achieved an efficiency ratio of 62% - not noteworthy, but in the right direction. The smallest community banks have been increasingly poorer performers, with efficiency ratios rising to nearly 69% [ILLUSTRATION FOR FIGURE 3 OMITTED].

4. Deposit growth in the smallest community banks has lagged the robust growth of high performing and medium size community banks [ILLUSTRATION FOR FIGURE 4 OMITTED].


In the current environment, community bank high performance is clearly tied to increasing non-interest income, improving efficiency, and increased size. So much for the obvious. Community banks, both large and small, get equal ROE "bang" for improvements in noninterest income and efficiency. In comparison, net interest margin changes have almost no effect on ROE when looked at on a normalized basis [ILLUSTRATION FOR FIGURE 5 OMITTED].

The signal in this data is that small community banks may never be able to do much about improved efficiency at their current size, since many operating costs are nearly irreducible. In other words, the community banking business has shifted to where optimal economy of scale does not kick in until after $100 million in assets. And to get this scale efficiency improvement, it is necessary to build assets within as tight a geographic area as possible, rather than simply size per se. This means prudent in-market acquisitions.

While it seems counter-intuitive that widened spread does not produce as much ROE impact as lowering operating costs or adding noninterest income, it is nonetheless the case, if only because margin is already the most significant factor in earnings. From the data presented, it would appear that strategies directed at improved net interest margin and asset volume may not be able to produce operating efficiency levels below 62%. Something more is needed. What community banks must do is to reach the "right asset size" for their market scope and do the best they can on holding or widening margins, while at the same time adding fee income and becoming more efficient. This is precisely what the high-performing community banks have already done.

Similarly, while it doesn't take a great deal of fee income to improve a community bank's earnings formula and performance, seeking such improvement solely from usual service charges is increasingly unfeasible because of continued price competition and consumer rebellion. This means either new fee products or nonbank acquisitions - or both. …

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