Community Banks Can Survive and Prosper – If They Adapt

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Matthew Yglesias’ Slate blog questioning the future of community banking triggered largely unsatisfying responses from community bank supporters (such as American Banker’s Paul Davis). The supporters exalt the myth of community banks – institutions with a limited geographic scope providing vital services to their communities. If community banks are unable to earn a sufficient return for providing these services, then it is unlikely that the services are vital to consumers. Unfortunately for many banks, they fail to earn enough to justify their continued existence in their current form. “Enough” is defined as earning a return on equity greater than your cost of equity. Survival is earned, not granted by size, location or noble calling.

At issue is the number of providers, bank and nonbank, needed for a strong financial services industry to serve consumer needs. This requires moving beyond traditional institutional definitions. Banking is what consumers do, not where they go to do it. Consumers are indifferent to who provides core services like credit, deposits and payments whether it is the corner store, a branch, an online bank or a nonbank.

Banks,in general, and community banks in particular, suffer from overcapacity. From 1995 to 2007, many community banks tried to cover up an eroding spread-based business model by using government-insured, subsidized deposits to engage in unprofitable, high-return, high-risk real estate loans. They lacked the skills to manage the risks effectively.

Unlike their protected too-big-to-fail cousins, community banks paid dearly for this mistake during the financial crisis. Hundreds of community banks failed or were merged out of existence. Hundreds more remain troubled. Returning to the pre-crisis leveraged real estate model is no longer an option.

Some see this as a sign of a declining industry. Rather, as a community bank investor, I see it as a healthy, albeit painful, reflection of the Creative Destruction process. Over time, community banks will become stronger and have improved long term prospects-provided they accept that the financial services industry is undergoing a transformation. They must re-examine their strategies and business models and experiment, improvise and adapt to exploit new market opportunities.

This requires focusing on the activities where you can add value and jettisoning the rest. The traditional model of bundling services through a branch delivery network is under attack. The competitive value of one-stop shopping, cross-selling and established relationships is being challenged by competitors employing new strategies. Competitive advantage will be determined product by product, not by the number of products offered. The biggest challenge comes from nonbank competitors and new entrants embracing new technology, not from other banks or regulators.

Virtual currencies, online banking, mobile wallets, big data, and social media are threatening to disrupt traditional banking the way they did numerous other industries like books, travel and electronics. Potential disruptors include peer-to-peer lenders, Wal-Mart, Amazon, Google Wallet, PayPal, and Facebook, to name just a few. Unlike the failed promise of 1990s dot com Internet banking, these new competitors are bigger, better financed and are likely to be formidable competitors a community banker cannot ignore.

Community banks, being smaller than megabanks, stand a better chance of adapting to the changing market. They can join with nonbanks to adapt new channels and technology – like the banks that are working with Lending Club – or act independently. Adapting goes beyond online or mobile banking. It involves embracing a new vision of financial services. It includes increased mergers and acquisitions, joint ventures and branch transactions as the size and composition of institutions adjust to new strategies. Banks with less than $1 billion in assets must avoid being trapped in the middle by either shrinking or becoming larger.

The future is not in the past with Bailey Building and Loan Association. Rather, it is yet to be drawn. Community banks can be important participants in this development. Those that do will thrive and produce attractive returns to investors, while those that do not will fade away. There are no mature industries, just mature managers and strategies. That is why I remain optimistic about investing opportunities in the evolving community financial services marketplace.

J.V. Rizzi is a banking industry consultant and investor. He is also an instructor at DePaul University Chicago.


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Banking is not the first industry to experience great challenges arising from the structural issues of a large number of relatively homogenous producers. Think about agriculture in the 80's. Ag producers of that time would talk about their business as a noble endeavor that was under assault as the ag crisis purged many farmers from the industry. Decades later that industry is very different, but also very robust. There is great potential for community banking. But, success will not be found by waiting for the old days to return.

"All courses of action are risky, so prudence is not in avoiding danger, but calculating risk and acting decisively. Make mistakes of ambition and not mistakes of sloth. Develop the strength to do bold things, not the strength to suffer."
- Niccolo Machiavelli
Posted by Neil Stanley | Thursday, December 19 2013 at 1:48PM ET
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