The traditional community banking model, while still viable, is being challenged because of economic, competitive, technological and regulatory forces—many of which are beyond the control of any individual community bank. The largest banks have used their massive size, product set, and more recently, technology, to make dramatic gains in market share at the expense of community banks. I believe that progressive community banks should be considering new ways of doing business, especially in regards to their lending strategies.
Community banks do many things far better than their larger competitors, while enjoying a degree of trust and resiliency that the megabanks may never achieve. But those big banks boast something the community banks, standing alone, cannot match: the scale to operate the lending platforms which are now necessary in most lines of business—including commercial & industrial (C&I) lending. Many American businesses now require loan amounts of $50 million or more, a loan size that typically defines the low end of the “middle market.” Those loans required by middle market borrowers, companies providing goods and services serving a wide range of industries, far exceed the individual lending capacity of the typical community bank. The teams required to source, screen, underwrite and manage these larger loans are typically out of reach for a community bank.
To date, those megabank advantages have clearly outweighed the strengths of community banking in C&I lending. Without the ability to deliver many of the commercial loans that middle market businesses require, community banks are stuck in a quandary in which they often have to turn away customers with successful, growing businesses. The numbers are clear: In 1990, community banks with under $10 billion in assets accounted for over one-third of C&I loans held on the balance sheets of banks. By the end of 2014, community banks’ share of the C&I market has dropped to just over 15 percent of the market. The continuation of this trend will likely limit the profitability and growth of community banks as well as their ability to positively affect their communities in other lines of business. Equally important, it also subjects those banks to less diversified loan portfolios and the risk associated with loan concentrations, particularly in commercial real estate.
While each community bank may individually struggle to match the scale of the mega-banks, it is important to keep in mind that the biggest banks are saddled with their own challenges such as bureaucracy, legacy systems, resistance to change, customer fatigue and burdensome regulatory oversight.
Community banks, but for their individual lack of scale, ought to be well positioned to capitalize on these opportunities and to outcompete the megabanks. The innovation required for community banks to break this logjam—to free them to focus on their strengths—is here, and its essence is this: community banks no longer need to stand alone.
They can prosper by working together, particularly in gaining access to middle market lending. Community banks do have the scale enjoyed by the biggest banks, they just don’t have it on their own. Together, community banks hold $2.3 trillion in assets—13 percent of the assets held by US banks, and just shy of the assets of JPMorgan Chase & Co., the largest US bank. The question is how to leverage that scale while preserving the individuality, proximity to the customer and legendary service that contribute to their unique value.
Community banks should consider joining together in alliances or cooperatives in order to gain access to C&I loans, including diversified sectors such as manufacturing, healthcare, technology, and business services. In addition to using such partnerships to successfully source these loans on a national basis, other benefits such as diversification (size, geography, and industry type), access to larger customers, and combined expertise in underwriting and loan management can be achieved. One such cooperative, BancAlliance, consists of over 200 community bank members and has sourced over $2 billion in such loans.
Through partnerships such as these, community banks can succeed in delivering loans to job-creating middle market businesses throughout our country at a reasonable cost to each community bank, while adding to their net interest margin and diversifying their balance sheet.
For most banks, organic growth comes from loans. Commercial real estate (CRE) lending is the top source for loan growth, according to the executives and board members responding to Bank Director’s 
In most acquisitions, the selling bank’s loan portfolio generally is the largest asset. Valuing it often consumes the majority of the valuation team’s effort. Achieving consensus on fair value can be challenging, as there typically isn’t an observable market price for most bank loan portfolios. In fact, the acquirers’ management often is surprised by the difference between its pro forma balance sheet projections and the final independent, third-party valuations. These unexpected changes in valuation could have a significant impact on the acquiring institution’s regulatory capital requirements and future earnings potential.
Basel III will generally require all U.S. banks, large or small, to hold more capital than under existing rules, especially in the form of common equity. The effect will be to incentivize banks to reduce their risk-weighted assets by reducing their exposures or their level of risk in order to maintain a sufficient return on equity to attract investors. The impact on bank mergers and acquisition activity is unclear. Increased capital requirements will drive banks as sellers, but will temper banks as buyers. But there will likely be a contraction in the supply of credit from banks, which may drive lending into less regulated parts of the financial sector. This seems at odds with the prevailing political push for more lending from banks and more financial regulation.
If adopted as proposed, the Basel III requirements will have a significant impact on U.S. banks of all sizes. Community banks were surprised that they were subject to Basel III at all, and the higher substantive and procedural burdens on both residential and commercial lending can reasonably be expected to force many of them to exit the industry. For the larger banks, much of what is in the U.S. proposals is consistent with what they have been tracking from the Basel Committee since late 2010. Nonetheless, the higher capital charges likely will continue to force the shrinking of business lines in the short term, and severely inhibit large bank mergers over the longer term. 
The impact will be positive in the long term. Basel III’s higher capital requirements will be phased in over a number of years. While many are eager for banks to become more generous lenders, Basel III’s capital demands encourage banks to husband their resources. The new capital regime will be a drag on economic recovery, but it ought to produce greater long-term financial stability. 
The real impact will be the change on Main Street. The proposed risk-weighting rules will require banks to tie up more capital with certain asset classes, which will cause banks to increase their pricing of those assets in order to achieve the same return on equity. Therefore, we can expect higher pricing for junior lien mortgage loans, highly leveraged first mortgage loans, and highly leveraged acquisition and development real estate loans.
The implementation of the Basel III regime will highlight the need for banks to be creative in their capital planning. We have already been assisting numerous community banks in capital raising initiatives to provide support for the development and implementation of lending and other income-producing programs, as well as strategic acquisitions or expansions. We are encouraging our clients, to the extent they have not done so already, to implement comprehensive capital plans that focus on careful management of existing capital resources and proactive research of available sources of future capital.
Basel III and the changes to risk-based capital regulations provide substantial penalties, in the form of increased capital allocations, for risk taking. Former chairman of the Federal Deposit Insurance Corp. Bill Isaac, in his book, “Senseless Panic: How Washington Failed America” demonstrated the pro-cyclical nature of mark-to-market accounting. Yet, the Basel accord now mandates it for the securities portfolio. The risk-based capital ratios dramatically increase the risk-weighting of several asset classes, including mortgages that are not “plain vanilla” and problem loans. Because such penalties have a potentially severe impact on capital, prudent bankers will reduce their risk of a capital shortfall either by rejecting loans at the margin or maintaining higher capital cushions. Either way, the credit crunch for all but the clearly creditworthy is likely to be exacerbated.
With traditional bank lending, one of the credit risk red flags was always a lack of borrower diversity. How could a company risk having all its eggs in one basket? The extra pain extracted from highly correlated bank portfolios (i.e. both with real estate and geographic concentrations) in this crisis has brought that proverbial chicken home to roost in our own industry. Conceptually, we all now understand this; how do we practically affect this change?