Four drivers of long-term industry change
By Philip K. Smith
To say the environment for community banks has changed over the last five years would be an incredible understatement. As the industry continues to dust off the debris from the recent financial crisis, community banks have found themselves in a state of flux—one in which analysts claim smaller banks cannot survive on their own, regulators seemingly ignore community banks when drafting regulations, and shareholders needs are shifting. In such an environment, we must prepare for change. Change is difficult for many community banks, particularly when they have been around for a long time. Nevertheless, we must be willing to change, not for change’s sake, but to do what it takes to move the bank forward.
Notwithstanding the large scale of the megabanks, community banks will continue to maintain a distinct advantage within the area of small-business lending, agricultural lending, and relationship or “high touch” banking. Large banks will continue to experience difficulty in integrating their operations and face constant pressure to centralize operations and decision-making for economic reasons. As such, a community bank always will be more nimble, more responsive, more flexible and more creative with its customer base and products and services, which will create a continuous competitive advantage long into the years ahead. To capitalize on that advantage, community banks must be knowledgeable of areas that will continue to change the face of the industry.
The regulatory environment
The regulators have been around for a long, long time and will be around far into the future. The regulatory burden will fall heavier on community banks due to their inability to spread the cost over a larger asset size and earnings base. It is likely that the regulators will continue to home in on hot-button issues and make examples of banks large and small in order to ensure compliance by others so the same thing “doesn’t happen to them.”
As you are already aware, a current hot-button issue is compliance, and it will likely remain so in coming years. This is not the compliance burden from the ’70s and ’80s, which primarily dealt with hyper-technical issues under Regulation Z, the Flood Act, the Community Reinvestment Act, etc. The compliance burden and issues that face community banks today primarily involve fair lending and unfair, deceptive and abusive practices. A violation in one of these areas can put your community bank in the penalty box for the long term. Once in the penalty box, it is virtually impossible to execute on your bank’s strategic plan. The reality is that the regulatory “corrective program” will likely not be consistent with the bank’s business plan for success, may not assist in attracting and retaining key personnel, and will divert significant financial and managerial resources to dealing with actions that will not sustain profitability or long-term franchise value for the institution.
Presently, approximately one-third of the industry is under some type of enforcement action. In this volatile environment, every community bank’s board and management team must understand how to effectively deal with and “manage” its regulator or an adverse regulatory exam. Each of the regulatory agencies has its own methods and its own agenda. For banks to remain profitable moving forward each must understand and navigate its regulator’s expectations.
Technology will also continue to be a dominant, long-term factor in the industry, specifically as it relates to meeting customers’ needs and banks’ geographic footprints. Fortunately, as I’ve indicated, community banks can be more nimble when it comes to implementing new technology. Particularly in the small-business arena, community banks will continue to rely on technology to further relationships with customers by determining the needs of those customers and meeting those needs with technology. For example, most customers will begin to utilize mobile devices that can engage in banking transactions from anywhere in the world. Accordingly, community banks must have access to appropriate technology and technology security to serve the large segment of the population that is migrating toward mobile banking.
Technology will also impact the geographical footprint of the banking industry. Banks are beginning to utilize technology in the form of virtual tellers, or “smart ATMs,” which accept checks, cash and other deposits, and allow for face-to-face communication with a bank employee at a remote location. In some cases, such technology eliminates the need for a brick-and-mortar branch altogether.
That said, although banks continue to evaluate the utility of their branches in efforts to cut costs and adapt to the increased use of mobile banking and other technology, it has been pretty much concluded that customers still like to deal with people, especially when they have a problem. As a result, banks will continue to establish brick-and-mortar branches, though the scale and makeup of those branches will change significantly.
In recent years, a number of community banks around the country have celebrated their 100th anniversary. When those banks were formed 100 years ago with a few thousand dollars in capital, their local shareholder base was very loyal and exhibited an emotional attachment to that bank and to those shares. As those shares are passed from generation to generation to generation, and as those generations move away from the location of that bank, the loyalty that once tied that shareholder to that bank begins to dissipate. We will continue to see that trend in the future.
This trend of the less loyal shareholder base dictates that community banks should focus on enhancing shareholder value, since many of these shareholders who no longer have an emotional attachment to their bank’s stock will be looking at it simply as a financial investment. To appeal to these financially minded customers, banks should generally focus on earnings-per-share growth through increased profitability or share repurchases, a respectable return on equity (10 percent to 12 percent is a good target, though it is harder to achieve in today’s environment), share liquidity and a dividend policy that is appropriate for the institution’s shareholder base.
Other factors affecting shareholder expectations are age and education. Current statistics indicate that the fastest growing sector of the population by percentage is individuals over 80. In addition to the effect of the “graying” of the population, the shareholders and customers of community bank services will be more educated. The impact of these trends on community banks is at least fourfold.
First, the shareholders’ investment intent will change from “growth” to “yield,” which will require increased focus on the four means of financial return discussed previously. Second, while banks’ products and services are becoming more mobile and technologically integrated on the whole, they will also need to distribute those products and services to these geographic segments of the population that are theoretically less mobile and higher aged. Third, due to technology, this age group will have better access to information on the bank and its competitors. Fourth, this group will likely travel more, have more leisure time and inherently become less loyal customers who need to be tied in with high-quality service and technology.
All community banks have suffered in large part due to low interest rates and compressed lending margins. Fortunately, interest rates will eventually rise. The question, of course, is when. The Federal Reserve seems determined to advance the ball down the field in the interest of keeping inflation low, but everyone knows that those tactics cannot and will not continue.
Going forward, community banks must be prepared for that interest rate risk by focusing on the loan portfolio as well as the investment portfolio. With the loan demand slack, many banks have put their liquidity into investments in an attempt to eke out a reasonable yield. As rates tick up, those investments will rapidly become under water. That issue alone could create some serious problems for some community banks.
Another economic issue we are continuing to see across the industry is fatigue. Borrowers are fatigued from operating in seriously down economic times. Bankers are fatigued from fighting battles to keep their banks well capitalized and in good graces with the regulators. Even regulators are showing fatigue (likely due to the increased fortitude of community banks across the nation), which has created a modestly “kinder and gentler” regulator, certainly for the seriously troubled banks.
As with interest rates, these issues will normalize. Borrowers will begin borrowing, which will improve bank capital levels and eventually regulatory relations. For now, the key is perseverance. As with any economy, there are times of recession and growth. Ours has hit bottom and is slowly on the rise.
As we look down the road ahead, the long-term future for community banks is promising. One of the most severe banking crises of many of our careers is mostly behind us, and community banks are well positioned to adapt to changes facing the industry. Their environment may have changed, but the purpose, vision and viability of community banking remains strong.