Community Banking Admist Rapid Consolidation

Community banking is a uniquely American institution. Locally owned financial institutions serving

their communities, drawing deposits from customers ranging from small savers to successful businesses, then lending those deposits back into the community ultimately to provide jobs and fulfill dreams, whether it be a new home, an education, or the creation of a new business enterprise. Community banking is both a business and a public trust. And today many of those community banks are disappearing.


A national trend is rapidly gaining momentum that will very likely result in 10 or less banks controlling 75% of the nation’s banking assets. This could well take place in the next 36 months. The 10 largest institutions, including their announced acquisitions, already control 40% of assets. One institution, BankAmerica, on a pro forma basis combining BankAmerica and NationsBank, controls $585 billion in assets, or 9.86% of the total U.S. banking assets. Thus the new BankAmerica will have 2.4 times the assets of the 5,163 banks with under $100 million in assets, which have $241 billion in assets or 4% of the total.

The trend toward consolidation is basically inevitable. Only one thing can slow consolidationu00e2u20ac”a major correction in the stock market or a market devaluation of banks in general, either of which would bring down the value of acquiring banks’ stock. At the end of the day, the price/earnings multiple of the acquiror determines who can grow by acquisition and who can’t.

The banking landscape today

The question often arises as to how many banks there will be, ultimately, in the United States. We look at it in terms of unique banking entities. Unique banking entities include multibank holding companies, individually owned banks and thrifts, and mutual savings banks. If you count each multibank holding company as one bank, disregarding the number of subsidiary banks, most of which in reality will become branches, the number of unique banking institutions is 8,536 and falling. Acquisitions totaled 435 institutions in 1996, 397 in 1997, and approximately 207 in the first six months of 1998, which annualizes to 414.

The real issue, however, isn’t how many banks there will be, but what will be the concentration of banking assets. In many ways, the consolidation of American banking is virtually complete. With 50 more major acquisitions by the 10 largest, the hunt will be over. Figures 1 and 2 illustrate the concentration of U.S. banking institutions and assets.

The acquiror’s viewpoint

From the acquiring bank’s viewpoint, three dynamic forces are driving acquisitions.

First, the stock market is placing historically high valuations on well-managed multibank holding companies. As a result, there is very real pressure to use this highly valued stock in terms of its purchasing power to acquire earnings-per-share growth. The bottom line for acquirors: Use your high-priced currency to make acquisitions, preferably nondiluted, while you can.

Second, internally generated growth in assets and, more important, revenues is getting more and more difficult to achieve. The bottom line: It’s much easier to acquire revenue growth than to build the bank one account at a time.

Third, an acquire-or-be-acquired frenzy is driving acquisitions, particularly among the larger institutions. In a world where $90 billion-asset institutions are regularly viewed as targets, the pressure is on the regional bank holding companies to both solidify their regional presence and look beyond their regions for acquisitions. The implication being, right or wrong, that if you’re not acquiring (which in itself may be suspect, as in “they are just bulking up to sell”), you are obviously just getting the bank ready to be sold.

Keep in mind, in the world of the larger institutions, reality is often shaped by gossip, rumor, and innuendo fueled by security analysts and investors who may not necessarily have a long-term view. That’s a diplomatic way of saying, “The only reason investors bought the bank’s stock in the first place was they hoped the bank would sell out.”

Rationalizing mergers of equals

Large-scale mergers of equals are actually happening. It’s absolutely amazing how two CEOs with dramatically differing management styles and temperaments can somehow miraculously enter into “co-management partnerships” with their former rivals. When the unlikely marriage is announced, the press briefing often sounds something like this:

“While each of us have spent our entire business careers competing internally for the undisputed title of CEO of our own organizations, we have now decided that we really, really want to share the power we fought so hard to get because we’ve gotten to know and respect one another so much. Most important, the merger will provide great benefits for both our organizations’ customers, employees, and stockholders…and incidentally, for myself and my new best friend.”

Question: In the 30 days following the announcement of any major merger, please estimate the amount of senior management time in both organizations that was spent on “How will we jointly improve customer service?” versus “What in the world does all this mean to me and my career?”

The community bank’s perspective

Experienced and responsible community bankers are facing a difficult decision. Either sell the bank to the highest bidder, maximizing its value for the benefit of all the shareholders today, or take up the challenge of leading the bank into a new era of technology, competition, and changing customer priorities with the possibility of greater or lesser value in the future.

Three factors are driving community bankers’ thinking regarding consolidation.

First, prices being paid for community banks are at an all-time high and few bankers believe they will go much higher. Most long-term bank stockholders simply hope they will remain where they are. The bottom line for those who are evaluating whether to sell the bank at this time: Don’t sell if you think prices are going higher. If you think prices are going lower, don’t sell if your believe your earnings are going to increase significantly enough in the future to more-than offset lower prices being paid.

Community bank CEOs’ perceptions about the significance of current valuations cover a broad range. Here are three examples. One seasoned banker said, “This is an absolutely perfect time to sell the bank. My earnings have never been higher and the prices being paid for banks like mine are at an all-time high. And I don’t think either my earnings or the prices being paid will be this high much longer.” Another banker recently told me even though his $200 million-asset bank was trading at 5x book and 29x earnings, he could point to a number of nonbank companies that were selling at equal or higher multiples. Hence he wasn’t particularly worried. Yet another highly successful, 63-year-old banker recently told me, “If the bank is worth the same or even 20% less in five years, I’ll be happy I didn’t sell. But if it drops 50% in value, that would really bother me.”

Second, earnings are at an all-time high. It really is the best of times, yet many bankers are concerned about the underlying fundamentals. Price competition, especially for loans is becoming highly focused on the bank’s best and most profitable customers. In addition, at some point we will see a return of the business cycle and with it the potential for increased loan losses. And operating expenses, especially the salaries required to attract, retain and motivate good employees, are rising significantly in most markets.

A unique way to look at viewing return on equity is to look at the return on the current valuation of the bank. For example, a bank with 12% return on equity that’s currently valued in the market at 3x book is earning a return of 4% on its current valuation. The question for some owners is, should they sell the bank, pay the taxes, and perhaps get better return on the current valuation or should they hold on in anticipation of either significant earnings growth or higher prices?

The toughest call to make in community banking today is what earnings will be on equity three to five years hence. Too many variables cloud the picture to come up with a clear determination, including: Will the already-extended economic boom we are in continue? How will a fundamentally changing competitive environment affect spreads? How will new technology impact the bank? How will changing customer priorities redefine the need for traditional banking services?

Third, the number of potential community bank acquirors that would competitively bid for the bank, giving it its highest potential value, are themselves fast being acquired or are focusing on acquiring only larger institutions. Virtually all large acquirors are becoming increasingly selective, because as one senior holding company executive told me, “It’s simply not worth the time and effort for us to buy $100-, $200-, or $300-million banks when we can still buy billion-dollar banks…. and we’re big enough to do those transactions.” The only problem, of course, is that there are fewer and fewer billion-dollar banks.

Pricing power, growth, and profits

The pricing power for many banks and businesses is fast disappearing. The ability to raise pricesu00e2u20ac”whether to cover increased costs or to simply increase profitsu00e2u20ac”is essential for long-term success. The effects of the Asian economic crisis may be troubling for many businesses. The economic witch’s brew of currency devaluations, rapidly declining regional economics, and the resulting necessity to export is creating a deflating price environment that could impact everything from energy to cars to tennis shoe prices.

Increased domestic price competition is also driving prices down. This is especially true where the purchaser views the products or services as commodities. Add to that the presence of increasingly large corporations with significant economies of scale, such as the Wal-Marts and Wal-Mart wannabes, the so-called “category killers,” and you have created a retail environment of extremely price-conscious consumers. Who among us wants to overpay for anything?

If pricing power decreases, where do banks and businesses make up the difference to maintain profits? The obvious answers include increasing revenues through more focused sales and marketing or by using more efficient technology, thereby reducing staff and other expenses. Somehow it all gets back to managing revenues and expenses to produce profits. The big question, however, is exactly where will banks in the future have the flexibility to build revenues and significantly reduce expenses?

High performers face unique challenges

Ironically, some high-performance banks are the most vulnerable to a decrease in profits. The reason is simply this: Many high-performance banks have pushed pricing on deposits, loans, and services as far as their local markets will allow and have reduced expenses to as low as can be commensurate with maintaining good quality service. In addition, due to a strong economy and excellent credit quality management, the provision for loan losses is often negligible. The bottom line for the high performers facing dramatically increased price competition for their most profitable customers is that they either must grow revenues or see their interest margins under very real pressure.

The successful high performers of the future will use the current environment to focus management attention on achieving profitable revenue growth. This will be accomplished by implementing integrated sales solutions that combine information, sales, and loyalty management. In all my conversations with leading high performers throughout the country with assets from $200 million to $5 billion, the single most recurring theme is simply this: “We are focusing on how to improve our sales and marketing.”

All the long-term financial service competitors are investing hundreds of millions of dollars to dramatically increase their sales effectiveness. Today’s high performers are starting to focus on implementing integrated sales solutions. Increasing revenues has clearly become their number-one priority; however, this time around, it’s not all the banks chasing a dubious lending category, but all of them focusing on a fundamental change in how they sell. And from everything I know, they are doing it thoroughly and professionally. Many of the high performers, especially community banks, will do it faster and more effectively than their larger competitors simply because they don’t have thousands of employees to train and manage.

It’s been said, “God is in the details.” Similarly, I believe winning is in the implementation of a plan. All the planning in the world is merely conversation until something gets implemented. That’s where the high-performance banks will stand out from all the rest. In addition, we see the genisis of a whole new group of sales-oriented community banks that will be the growing high performers of the future.

A real banker: the new delivery channel

Amid all the focus on high-tech delivery channels, a clear opportunity for community banks is emerging in the search for new delivery channels for financial services: It’s called a banker. Not all customers’ businesses readily lend themselves to automation; not all customers desire that approach. The bottom line is that those customers who want the long-term services of a banker and are willing to pay a slight premium for it will be the customer base for community banks.

Today, many of the leading banks are actively pursuing individuals and small business with substantial lines of creditu00e2u20ac”using a high-tech approach that relies heavily on credit scoring. This approach will be very effective in a booming economy. In the next phase of the business cycle, many customers will learn that remote lending cannot supplant the importance of a real banker who knows and understands the customer and his or her business.

Over the next three to five years, most community banks will begin offering a broad range of products and services, complete with internet/home banking. While many of the total product offerings will not be as robust as the larger financial service competition, the local presence of a seasoned banker may sway many customers in determining whether to stay with their existing community bank, or perhaps move their monies from a larger institution.

The loyalty of profitable customers will have to be earned and re-earned daily in the new competitive environment. The list of highly profitable customers that any bank can take for granted is becoming shorter everyday. The first step is to learn exactly who the bank’s most profitable customers are, rank them in terms of dollar profitability, and then look for the “overlooked” and “underappreciated” as well as the known best customers.

Window of opportunity

My estimate is that there is a two- to three-year window of opportunity depending on exactly who the most threatening competition is in the local market. After that, community bankers can expect both highly focused price competition, especially for loans, and total financial service competition, including cash management, financing, investment management, retirement planning, and insurance from a single-source provider. Most important, the competition will be targeting only the most profitable customers in the market.

The bottom line: Community banks have a window of opportunity to identify their best customers and solidify those relationships before the competition from the majors gets both significantly more intense and more effective. Community banks can win if they are committed and get started as soon as possible, because implementing an integrated sales solution takes time. There are no quick fixes. The rewards, however, can be very significant in terms of growth, earnings, and increased shareholder valueu00e2u20ac”without selling the bank.

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