Diversification for Community Banks

The buzzword in today’s banking world is “diversification.” Bankers Trust’s acquisition of Alex. Brown, NationsBank’s acquisition of Montgomery Securities, or Fleet Financial’s acquisition of Quick & Reilly are just a few of the more visible diversification transactions recently completed. Many observers believe this diversification is essential to survive and adequately compete in the consolidating financial services market.

Although consolidation is most visible at money-center or superregional institutions, the strategy has meaningful importance to the community banking sector as well. Through a carefully planned strategy of diversification, community banks may be able to prosper, rather than to fall victim to the consolidation trend in the industry. It is clear that new skills and a different orientation are essential to successfully diversify and that priority needs to be to placed on both revenue and earnings growth to survive.

Behind the urge of the banking industry to diversify are three vital influences. First is the driving force of demographics. According to the U.S. Bureau of Census, over the next 20 years, the age group 45-64 will grow by 66%, and by the year 2000, 40% of the U.S. population will be over the age of 65. This shift in demographic makeup indicates a greater demand for investment products relative to traditional bank products.

Second, bank market share is eroding as financial assets continue to migrate to nonbank competitors, such as insurance companies, brokerage firms, and mutual fund companies. Competition is intensifying for community banks due to the growing number of nonbank competitors, the increasing size of both bank and nonbank competitors, and the enhanced pricing power of larger entities. According to the FDIC, the community banking sector has lost over half of its market share of C&I (commercial and industrial) loans and consumer loans since 1984. Today, community banks control approximately 3.2% of total household assetsu00e2u20ac”down from twice that amount 10 years ago.

Finally, the playing field for banks has become more expansive as federal and state regulations have eased, giving financial institutions much broader powers. Several of the most commonly recognized diversification options are mortgage banking, money management, insurance agencies, commercial and consumer finance, and equipment leasing. These service-related businesses improve noninterest income levels, resulting in a more diversified income stream.

Mortgage banking origination operations favor a retail style that can more easily

be integrated with existing consumer lending, versus a wholesale operation in which the origination is more independent. Conversely, mortgage servicing often is impractical for many community banking organizations, because scale/size requirements prohibit a meaningful profit margin. The successful mortgage banking opportunities for community banks will be to acquire niche companies that provide a higher level of service to their segment of the banking market.

Insurance agency acquisition is a natural extension of the community banking franchise and already has been proven successful by banks in many regions of the country. The entry into insurance fits quite naturally with a community bank’s retail and small-business customer base. The cross-selling of insurance and banking products can be very profitable, and it enhances and broadens customer relations.

Other nontraditional avenues for expansion and acquisitions by community banks include commercial and consumer finance and leasing operations. Initiatives in these businesses will enable community banks to mature into well-rounded financial services companies by developing and/or expanding the profitability of existing customer relationships.

Banks have explored all of these nontraditional diversification opportunities as a means to

• insulate against economic cycles by diversifying away from “spread” revenues
• respond to changing customer demands and capitalize on shifting demographics
• compete with or become “one-stop” financial centers
• generate more profitable business lines as their existing products (mortgages, credit cards, etc.) become commoditized and less profitable
• leverage or extend existing business/customer relationships.

As the pace of consolidation and diversification intensifies among larger institutions, community banks inevitably will be subjected to growing pressure to join in. Viewed differently, success for community banking now mandates a commitment to customers whose needs are not easily commoditized. Diversification reinforces the relationship between community banks and their customers and results in a more balanced revenue stream, and, to some degree, an insulation from the effects of various business and economic cycles.