July 10, 2013
Authored by: Dan Wheeler and Jonathan Hightower
In a recent strategic planning meeting, a bank chairman opined that “community banking is dead.” He is not the only banker and his is not the only bank grappling with this concern. After that meeting, we solicited the input of many of our peers in the industry. Were increasing expenses and shrinking margins killing community banks? Was the ever-quickening pace of technology too much for community banks to overcome? Were the building regulatory demands insurmountable for community banks? As we asked our peers these questions, many of them gave multi-faceted answers based on different assumptions of exactly what was meant by “community bank.”
Around the same time, the FDIC proposed its own definition of “community bank” as a part of its Community Banking Study, which was published in December 2012. This study not only defends the viability of community banks but also introduces a thought-provoking definition of exactly what constitutes a community bank. The definition includes a component related to size and a component related to core deposit gathering. It also includes components related to the number of offices and percentage of loans to assets. The focus of this article, however, is the following two criteria:
- simplicity of business plan; and
- operating within a limited geographic area.
We believe those two criteria are worthy of focus as indicators of value for smaller banks and may be keys to success for many community banks.
The two areas of focus are related. Both are based on a key principle of many successful community banks: do what you know and do it well. In the early and mid-2000s, many of the banks that were viewed as community banks were busy pursuing one of two strategies: getting ready to sell as quickly as possible or getting as big and diversified as possible by putting offices in all of the growth markets they could. For many, pursuing a sale worked out wonderfully for the institution’s shareholders. But, many banks became overextended in growing and building their “platform” and paid the price.
The reason that the growth and diversification strategy was not effective for so many banks is that those banks got away from the lines of business and geographic areas that it knew best. By focusing on limited and traditional product offerings and operating in limited geographic areas, a bank and its staff can truly become an expert in its products and its customers. Everyone in the organization, from the tellers to the directors, becomes familiar with the business of the bank and the constituencies that it serves. The institution truly develops an identity and a culture that it can build around. Much like a good strategic plan, this identity informs every decision made in the bank, ensuring that day-to-day and strategic decision-making are consistent and principled, rather than being driven by the perceived need to match a competitor’s terms.
In addition, by focusing on traditional lines of business and limited geographic area, community banks can truly implement the customized decision-making that they are known for. Expanding into new markets and new product lines causes banks (and all businesses) to become more reliant on standardized policies and procedures, rather than making decisions quickly and effectively based on all relevant factors, even those factors that may not fit neatly into a standard model. By “keeping it simple,” community banks can bring their unique market and product knowledge to bear in ways that larger competitors cannot.
This approach to banking, however, is not without its problems. In an era in which regulators are focused on (and some might say obsessed with) concentration risk, it is increasingly difficult to implement a “do what you know” strategy. After witnessing the recent commercial real estate meltdown, regulators remain wary of what they characterize as an “excessive” concentration. However, while bank boards and management teams are charged with implementing effective risk management models, including necessary diversification, board and management team members should balance concentration risk against what frequently proves to be a greater risk, i.e., entering into a new line of business or new geographic area with which the bank does not have the requisite level of knowledge and expertise.
For example, many banks that once proudly proclaimed themselves to be real estate banks are now increasingly focused on making commercial and industrial loans. While there is absolutely nothing wrong with updating a business plan to adapt to a changing environment, many of these banks are undertaking this new line of business using the same lenders that made real estate loans for decades and have received little new training. In many cases, it is doubtful that these lenders understand the small businesses to which they are lending well enough to effectively underwrite and monitor the loans. In addition, the board members may not be familiar enough with the new business line to establish effective policies and effectively oversee the line of business.
In contrast, many community banks are well advised to carefully study and adopt suitable products and acquire expertise that enhance the products they already know well. For example, banks can acquire systems or hire expertise to allow them to have a sophisticated understanding of loan and deposit pricing, more efficiently manage compliance tasks for their existing products and hedge interest rate risk building in their portfolio.
The FDIC’s Community Bank Study is filled with useful data and analyses, and it is a worthwhile read for any community banker. Perhaps the most valuable information is the definition provided for community bank. We encourage community bankers to think about how the definition applies to their bank and if going back to the “do what you know” business model could benefit the bank and its shareholders. While community banking is under stress, it remains very much alive and we believe it will thrive, even in an environment of low margins and heightened regulatory burdens.
This article was first published in the Western Independent Bankers Directors Digest.