The Case for Rating Community Banks Investment Grade

For years, legacy rating agency thinking held that community banks could not be rated investment grade. They were too small, the thinking went, and therefore could not compete with scale-advantaged larger banks. Moreover, this structural deficiency likely made community banks riskier, as they were naturally subject to adverse selection in terms of loan originations.

All of this is intuitive. But it doesn’t stand up to further scrutiny.

If we consider the history of bank failures, we see that very small banks and very large banks are disproportionately represented. Meanwhile, well-run community banks, with long-standing ties to local markets, core deposit funding and well diversified risks have a long history of successfully riding out credit cycles. That piqued our interest. But we still needed to get over the hump of competitiveness. How could a community bank’s cost structure—the basis for pricing assets and liabilities—match the efficiency of the largest banks? We took a closer look.

Started with funding costs. Turns out that government guaranteed deposit funding—available to all FDIC-insured institutions, large and small, is a great equalizer. In fact, most community banks derive substantial amounts of their funding via core deposits, giving them an advantage over the largest banks that require substantial sums of more expensive market-sourced funding.

What about operating costs? Surely, the largest banks enjoy substantial economies of scale relative to community banks. That may be true, especially in terms of being able to absorb things like the significant increases in regulatory reporting and compliance costs. What we found interesting, however, is that the efficiency ratios of community banks in many cases compare favorably to those of the larger banks. Our research came up with two explanatory considerations. First, according to the FDIC, the benefits of economies of scale are realized with as little as $100 million in assets, and second, among larger banks, the benefits of scale are typically offset by the added costs brought on by complexity and administrative friction. This serves as a reminder that, in terms of competitiveness, banking, especially small to mid-sized commercial banking, is a local scale business, not a national (or international) one.

Now, you might point out, broader and more sophisticated product offerings must tip the scale in favor of larger banks. And there must be some benefit to the substantial technology and marketing spend of the larger banks. We wouldn’t disagree. But we also believe community banks can punch back with value of their own created out of local market knowledge and relationships as well as superior responsiveness. And most small businesses really don’t demand a sophisticated product set, and marketing spend generally creates value in consumer financial services, much of which left community banking some time ago.

So, what about the risk side of the equation? Larger banks by definition will have greater spread-of-risk than community banks, where risks are more concentrated, certainly in terms of geography, and quite possibly loan type (most notably CRE). What our research found was that through cycles, community banks’ loss rates per loan type were typically better than those of larger banks. In other words, no evidence of adverse selection, and a realization that most markets in the U.S. are relatively well diversified economically.

This is not to say that all community banks are investment grade. Well-run community banks can be rated investment grade. Therein lies an essential element of our rating determination—an in-depth due diligence session with senior management. Here, we look to understand the framework and priorities for managing risk, key aspects of growth strategies, and the rationale underpinning capital and liquidity structure. This is a story sector, and the management evaluation is critical to our rating outcome.

Our research suggests that well-run community banks can compete successfully with larger banks, and generate solid fundamental performance through the cycle. We rated our first community bank in 2012, and today that figure stands at 115 and counting, testament that our approach has resonated with investors and depositors alike.