Is There A Future for Small Banks in America?

In the movie, “It’s a Wonderful Life,” an angel shows George, a suicidal community banker, that his life really did have a positive impact on the people around him. The angel consoles George and brings him back from the brink with a message: “Remember: No man is a failure who has friends.”

That message is one that community bankers have long taken seriously. The close contact with their customers and the relationships that they cultivate for decades has been a source of pride for hundreds of years. Many of their banks have survived with simple business models based on taking in deposits and giving out loans, models that have worked through several financial crises, including in some cases the Great Depression. Many community bankers and their boards have no desire to grow their banks, sell out or get rich. Having a handful of branches and some solid relationships in the community is about all they want.

With thousands of banks throughout the country operating under much the same premise, is that way of life now under siege? Small banks would seem to have few friends in Washington, where Congress has passed new laws that are hurting bank revenue and increasing compliance costs even for the little guys. That is happening at a time of low interest rates, low profitability and low demand for loans. And this comes after two decades of a slow and steady decline in the number of community banks in the country, from about 14,324 banks and thrifts under $10 billion in assets in 1992 to just 7,000 today. So while the nation has lost about half of its banks and thrifts during the last 20 years thanks to consolidation, banks above $10 billion in assets now control 80 percent of the industry’s assets, up from control of 35 percent of the industry’s assets in the early 1990s. The struggles smaller banks face to compete and make a reasonable profit for investors are real, and the nation is expected to continue to lose its community banks, especially those below $1 billion in assets, which make up the vast majority of banks and thrifts in this country. Still, there are sources of strength in community banking, many of whom will survive if they do what they do best.

The ones who haven’t survived illustrate the pressures on small banks today. Just four years ago, First Louisiana National Bank had three offices and was headquartered in the metropolis of Breaux Bridge, which likes to call itself the crawfish capital of the world. It has 2,800 households and an average per capita income of just $15,000 per year.

James Fontenot was its president and chief executive officer (CEO) and a founder of the bank 29 years ago. He had no urge to grow his $115-million asset bank. The bank was profitable.

That changed in 2010, when federal regulators implemented new rules on overdraft fees. No longer could banks automatically enroll customers in overdraft protection programs, an important source of income for many banks. Customers would have to opt-in to overdraft programs for the first time. The Federal Deposit Insurance Corp. (FDIC) also issued new guidance saying all depository institutions that were federally insured, even institutions the size of First Louisiana, must start contacting customers who repeatedly overdrew their accounts and counsel them about how to avoid such fees.

The bank only had 50 employees, and seven of them were devoted full-time to compliance with government regulations. Fontenot didn’t feel he could afford another department to counsel customers on overdraft fees even as the bank lost overdraft revenue. He would also have to monitor each individual’s activity closely.

Plus, profitability was getting squeezed because interest rates were so low. On top of that, Fontenot says federal regulators stopped his bank from giving out high-cost, short-term loans to people who couldn’t prove their income, such as fishermen, who had trouble getting loans elsewhere. That was an important niche business for First Louisiana. He says regulators began requiring him to offer fixed-rate, five- to seven-year loans instead of three-year loans. But he didn’t want to take the risk of having a bunch of seven-year loans on his small loan portfolio, when he didn’t know whether interest rates would rise over seven years and he would be caught paying more for deposits. For a big bank, it wouldn’t be a big deal. For First Louisiana, it was.

“I sold my bank and I’m glad I did it,” he says. “The compliance with federal regulations is so overwhelming; you can hardly do it anymore. We just didn’t see any let up in compliance and the adding on of more and more federal regulations.”

Nowadays, Fontenot is still sitting in his office seeing the same customers he always catered to, but this time, he’s working for MidSouth Bancorp, the Lafayette-Louisiana-based holding company that had $1.2 billion in assets when he sold First Louisiana to it last year. Now, he’s helping his customers navigate a slightly larger bank’s rules and underwriting process.

“My customers tell me all the time, ‘It’s not the same, it’s not the same,”’ he says. “MidSouth can’t operate like a community bank.”

He still thinks MidSouth has better customer service than the truly big banks, but even MidSouth has multiple people involved with the underwriting process, not just one person saying “yes” or “no,” and that can slow down response times compared to smaller lenders.

“As you get bigger and bigger, you lose the ability to get close to your customer,” he says.

It’s up for debate what exactly constitutes a community bank. Banks below $1 billion in assets tend to think that only they are true community institutions. Many banks above that asset size think they should be included as well, and since there is no agreed upon asset size that automatically delineates between the two, “community banking” might be as much an attitude as anything.

It’s safe to say all of them strive to provide a high level of customer service based on close contact and personal relationships. Smaller banks consistently outpace bigger banks in terms of customer satisfaction, according to research firm J.D. Power and Associates.

Most of them can’t outshine the big banks in terms of the latest banking technology and mobile applications. They also don’t do very well competing on price alone. Still, they are an enormously important part of the banking system, particularly for small businesses and farms. Banks below $1 billion in assets make up 10 percent of the industry’s total assets but provide loans to 37 percent of all farms and small businesses, according to the FDIC.

Losing more community banks could have an impact on customer service and access to non-conforming loans.

“Community banks make a living in non-conforming loans,” says Cam Fine, president and CEO of the Independent Community Bankers Association of America (ICBA). “That’s their great strength. That’s why their lending to small business is so prolific.”

Already, small banks are cutting back on customer service in order to handle increased compliance costs.

Laredo, Texas-based International Bancshares Corp., which sits on the Mexican border and is the holding company for Commerce Bank, just stopped doing mortgage loans out of its southern Texas branches last year, consolidating that service into a mortgage department several hours away in Austin, Texas. The holding company has several bank subsidiaries that do business under separate names, and has $12 billion in assets.

Customers of Commerce Bank who want a mortgage now can only talk to someone on the phone about it. Compliance costs were a major reason for the change, says Ignacio Urrabazo, the president and chief executive officer of the $500-million asset bank.

“[With mortgages], you have to make sure your t’s are crossed and the i’s are dotted,” he says.

He blames the Dodd-Frank Act for putting added pressure on bank balance sheets with a host of new regulations, including the creation of the Consumer Financial Protection Bureau and new rules for mortgage forms and servicing.

“When they passed Dodd-Frank they said it wouldn’t affect small banks but that was a bunch of baloney,” he says.

In addition to Dodd-Frank, Basel III, the new international agreement for banking, will impose stricter capital rules. Federal bank regulators have proposed extending those rules to community banks as well. That will impact small banks to varying degrees, depending on the type of capital they now hold. Urrabazo isn’t sure how the agreement will affect his bank. Raising additional capital to meet the requirements, however, wouldn’t be easy.

“The prospects of getting outside capital are limited,” Urrabazo says. “Investors are saying they have other alternatives [for investing]. Will the bank offer a fair return?”

Commerce Bank has the support of a much larger holding company and access to the public markets, and so will probably survive, Urrabazo says. However, what will be the fate of smaller banks that don’t?

“Where do you get full-time compliance people to work for you and how do you get them to [a town like] Laredo, Texas?” he says. “Sure, we will survive. But someone will suffer. Is it the consumer? The community? The owner of the bank?”

Fine of the ICBA thinks the nation will continue to lose small banks as the industry consolidates, partly as small banks try to get bigger to lessen the cost of compliance. He says the average community bank has just 40 employees.

“[For a new regulation], the bank will almost always have to change its software system; it has to change its forms; it has to train its employees and notify its customers,” he says. “Any new regulation costs money and it can cost a lot of money.”

Fine thinks the impact will be significant in small towns and rural areas and for those small businesses that otherwise can’t get a loan from a big bank.

“Where do those people get their loans?” he asks. “Who has the knowledge about the local farm or the local business? Who is going to serve those needs? That’s a problem that Europe has and that China has. The big cities do just fine but [loans are hard to get] in the rural areas because they don’t have a community banking system.”

Rural areas are losing population, so it makes sense they could be losing banks, too.

“Where the clients are being hurt are in rural markets that had small banks that might not have a bank anymore,” says Paul Schaus, the president of consulting firm CCG Catalyst Consulting Group in Phoenix, Arizona.

That’s what happened in Baldwin, Louisiana, a town of roughly 2,500 people, which survives on agriculture, the oil industry and a nearby casino.

Wayne Breaux, the mayor of the town of Baldwin, fought hard to get a bank in his town about a decade ago when it lost all its bank branches to consolidation.

“It takes quite a bit of time to do your banking out of town,” he says. “It’s somewhat of a perception problem as well. When you have a community that doesn’t have a banking facility, it’s hard to encourage any other growth as well.”

Breaux had actually been on the board of directors for one of the banks that disappeared, St. Mary Bank and Trust Co., which was based in nearby Franklin, Louisiana, and sold to Regions Financial Corp. in Birmingham, Alabama, 13 years ago. Much to Breaux’s consternation, Regions later decided to close the bank’s Baldwin branch.

Breaux did get a bank to open a branch in Baldwin several years later. A new casino on an Indian reservation nearby and a new subdivision helped encourage First National Bank of Jeanerette to open a branch, he says.

So in the end, Baldwin got a bank back. There is evidence that the loss of community banks might not be all bad, particularly in terms of access to credit.

The decline in the numbers of banks during the last 20 years can be traced partly to the dismantling of banking laws in the 1980s and 1990s that allowed states to restrict or forbid out-of-state banks, such as the Bank Holding Company Act of 1956 and the McFadden Act of 1927, says Geri Forehand, director of strategic services for Sheshunoff Management + Consulting in Austin, Texas. Many states had laws that forbid banks from crossing county lines, which encouraged banks to stay small, Forehand says.

Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act in 1994 to promote interstate banking, and the Gramm-Leach-Bliley Act in 1999, which repealed Depression-era laws that separated commercial and investment banking. Those laws allowed for the growth of behemoths such as Bank of America, which was formed after a series of acquisitions by Charlotte, North Carolina-based NationsBank. Another Southern bank that went on an acquisition spree, First Union Corp., eventually became Wachovia Corp., and now the even bigger Wells Fargo & Co.

Meanwhile, community banks continued to consolidate, with most of the banks that disappeared having fewer than $100 million in assets. Heavy losses in the last 20 years were also experienced among thrifts, which focus lending on real estate.

The impact of deregulation and the further concentration of assets in the banking industry has been much debated, but there certainly has been a lot of lending going on, even as the number of banks has dwindled. In fact, lending blossomed in the decade that followed the passage of Gramm-Leach-Bliley, albeit misguided lending that fueled a housing bubble and lead to the Great Recession.

Community banks got heavily into real estate lending, particularly in the funding of new subdivisions and other developments. The concentration of commercial real estate loans in loan portfolios burgeoned among banks below $10 billion in assets, while actually declining among banks above that level, according to data from the FDIC.

Not everyone thinks the loss of small banks during the last 20 years has been detrimental to businesses and consumers.

“I don’t think the small business person has been impacted negatively by going from 14,000 banks to 7,000 today,” says Forehand. To Forehand, small businesses still have access to loans, just at a variety of slightly larger institutions.

He argues that banking has gotten a lot more convenient for businesses and consumers during the past 20 years, with interstate banking and technology such as the Internet and mobile banking. Bigger banks are better able to afford that technology and offer more products and services to their customers.

Smaller banks might struggle to spend the same amount of money on technology, but they still often offer Internet and mobile banking and remote deposit capture anyway.

“It is a cost to offer mobile banking,” Schaus says. “If I want that cool app that Wells Fargo has, a lot of community banks can’t compete with that. They are trying to get bigger so they can offer more services. A [$100 million bank] can only afford the basics.”

Banks that don’t adopt new technology are in danger of becoming irrelevant, says Forehand. But many community banks are making smart decisions about what to deploy and when, and being small doesn’t mean they can’t offer many of the same products and services as much larger institutions. Fiserv, a Brookfield, Wisconsin-based technology company, provides mobile banking products to about 1,000 banks and most have less than $500 million in assets, says mobile product manager Calvin Grimes. He won’t comment on Fiserv’s costs but says the industry average cost is about $1 to $5 per month per customer. So the cost of mobile banking can reach $50,000 per month if 10,000 customers sign up.

But where a smaller bank can truly shine is not so much in technology as community service and niche banking, or going after customers that aren’t served well by their larger competitors, says Forehand. “You have to identify those segments you specialize in,” he says. “Banks cannot be all things to all people.”

Banks that identify customers who aren’t well served by the cookie-cutter models of the bigger banks have an opportunity, Forehand says. Many small business customers will pay a little extra in interest payments to get good customer service.

Jim McCormick, the president of First Manhattan Consulting Group in New York, has found that, contrary to popular belief, smaller banks actually are grabbing market share from the bigger banks, often based on customer service.

His analysis of deposit market share from consumers and small/medium-sized businesses excludes deposits in non-retail branches, such as Citigroup’s one office in New York that has $50 billion in deposits, which is 1,000 times bigger than the typical branch. If those deposits were held by consumers and small businesses, the line for the teller would be winding itself several times around the block, he says.

Measured organically on an acquisition-adjusted basis, the banks below $10 billion in assets are actually gaining retail deposits from consumers and small businesses during the last seven years, going from having 35 percent of those deposits in 2004 to 39 percent last year, McCormick says. Even the subset of those banks from $1 billion in assets and below are gaining market share from the bigger banks, going from 20 percent to 23 percent of retail deposits during the same seven-year time period, he says.

“[Community banks] don’t have fancy technology and they don’t have their names on stadiums but they’re winning in terms of growth of deposits and that’s based on customer service,” McCormick says. “The main point is that for serving the retail and small business needs of Main Street America, banks smaller than $10 billion actually have a greater market share than is widely perceived and that’s been growing, which is at odds with commonly held perceptions. These banks don’t have a dominant branch position and yet they’re winning.”

That’s not to say consolidation won’t continue. Joey Warmenhoven, a Portland, Oregon-based community bank analyst at investment manager McAdams Wright Ragen, says he expects further consolidation in the industry to heat up over the next year.

“I still firmly believe there is always going to be a place for a well-run, well managed community bank, no matter what market they are in,” he says. “We still have a number of banks that are very profitable. Most of them are efficient, the expense structure is low, and they know how to give good loans to good borrowers and attract [low-cost] deposits. A lot of borrowers decide to go with community banks because of the service level. They can pick up the phone and get ahold of someone right away.”

Greg Mitchell, until recently, the CEO of Irvine, California-based First PacTrust Bancorp, stepped down following the announced acquisition of The Private Bank of California. He says smaller banks such as his charge a little higher interest rates than the big banks, but it is worth it for their customers to have a better relationship with their bank.

“We hope to be the guardian of the concept of community banking in California,” he says. “Consumers want to be treated with dignity and respect and they want to connect with a person, not some monolith.”

First PacTrust does commercial real estate and commercial and industrial loans, and sees an opportunity for residential mortgages as well. The bank’s customers, including dentists and mechanics who own their own businesses, can get a loan from a big bank, but they don’t like the big bank’s one-size-fits-all way of doing business, he says.

First PacTrust is well capitalized, but Mitchell knows plenty of other community banks that aren’t.

“It is very sad,” he says. “These are banks that survived the Great Depression and they’re on the point of saying, ‘I can’t do this anymore or I won’t do this anymore.’”

In contrast, First PacTrust, which raised $33 million in a public offering in April, has been buying other community banks and plans to be a survivor.

“Those that make it through this storm, I think, will do well,” he says.

McCormick says the case for community banks surviving is that they have a better customer experience, they are gaining market share and they tend to keep things simple and straightforward.

Forehand says that banks that find their niche and become the best at delivering solutions in that niche will survive.

“I don’t think we’re going to lose community banks,” he says. “There is still a need for a community bank.”