Is the Community Bank Business Model Broken?

For the last two and a half years, the United States has actually been engulfed in two banking crises. The big one-the systemic one involving the likes of Washington Mutual, Lehman Brothers, the securitization market and Norwegian pension funds that found themselves owning collateralized debt obligations containing highly toxic subprime loans-has been discussed and debated ad nauseum. Whether you believe the federal government’s Troubled Asset Relief Program was justified, or consider it to have been a colossal waste of taxpayer money, I think we can all agree that Lehman’s failure in September 2008 rattled the global financial markets unlike any other event in a very long time. Perhaps the markets would have stabilized without Washington’s extraordinary intervention, or perhaps they wouldn’t have-but convulse they did.

This systemic crisis seems to have been largely resolved. Although significant problems remain-the securitization market is still in a deep coma, for example-a feeling of equilibrium has returned to the global capital markets. Most of our large financial institutions are stable and profitable. And I don’t get the sense that bankers, large corporate borrowers or regulators are worried that another Great Depression is lurking around the corner.

There is, however, a second ongoing crisis involving community banks-and how that situation gets resolved remains to be seen. There were 157 bank failures as of mid-December 2010, compared to 140 in 2009 and just 25 in 2008. The Federal Deposit Insurance Corp.’s list of problem banks was approaching 900, raising the very real possibility that failures haven’t peaked yet. The recession is over and the global financial markets are breathing easier, but many community banks are still in trouble. The floodwaters keep rising and not every small bank will reach higher ground in time.

While each bank failure has its own set of circumstances, the common denominator in a great many of them is commercial real es-tate-as in way too much of it. This comes as no surprise to people who follow the industry. For the last several decades, community banks have watched as the securitization market and the big banks took control of one asset class after another, including credit card and automobile loans, home mortgages and even small business loans. But one honey pot that was abundantly available to community bankers through the 2000s was commercial real estate-particularly loans that were tied to the booming U.S. housing market, like real estate development. Predictably enough, many community banks took advantage of the opportunity. And when the housing market collapsed, it took many of them down with it.

The plight of community banks today might not rise to the level of a systemic crisis, but it has significant ramifications all the same. It’s an important issue for the economy because community banks collectively finance a lot of the economic growth in a nation where most people work for small companies, and banks that are fighting for their survival probably aren’t lending much. The situation also has a huge impact on the entire banking industry. The FDIC insurance fund finished up the third quarter of last year with an $8 billion deficit-largely due to the failure of small banks-and that could lead to higher insurance assessments down the road.

Is the community bank business model broken? I believe the concept of community banking is still viable, but the model that many small institutions employ has to change. Simply put, they need more asset diversification and less risk concentration. They have to develop fee-based businesses that will leave them a little less dependent on lending, and additional lending capabilities that leave them less exposed to the cyclical commercial real estate market. This is easier said than done, and not every community bank management team will have the chops to execute a successful diversification strategy. My guess is that many of those who don’t will eventually sell out, leading to more industry consolidation.

I’m pretty sure about one thing, though. Judging by the proscriptive nature of the Dodd-Frank Act, the powers that be in Washington are more focused on tightening the screws than loosening them for banks, which means that community bankers will have to solve this problem on their own.

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