More than Regulation Is Killing Small Banks

The cost of regulatory compliance and its effect on profitability and competitiveness is a frequent topic of discussion among community bankers, Congress and regulators. But is the regulatory impact on profitability the only reason why community banks are shrinking?

For the past 25 years, the number of community banks has been consistently shrinking —from 14,408 in 1984 to less than half at 6,356 in 2011. At the same time, the number of community banks with a specialty in commercial real estate lending has increased from 2% in 1984 to 24% in 2011. As of December 2012, community bank loans secured by commercial and residential real estate make up the largest categories of assets.

During this same period, banks with CRE or mortgages as their main specialty were the worst performers by pre-tax return on assets. Those two groups had a weighted average pre-tax ROA of 0.64% and 1%, respectively.

The Federal Deposit Insurance Corp.'s Community Banking Study in 2012 also points to long-term shifts in bank lending strategies, especially after 2000. Hundreds of banks during that period moved out of the community banking baseline specialties of mortgage, agriculture or no specialty into what they saw as more lucrative deployments of capital. Focus on CRE as the primary specialty was the biggest shift in lending strategy. Between 1991 and 2007, the number of CRE specialists increased five-fold from 474 to 2,274, with an increase of 1,400 banks between 2000 and 2005 alone. The shift was also defined by large increases in the construction and development portfolio holdings.

In 2010 and 2011, more than 50% of the banks that had increased their C&D holdings by more than 10% had either failed or were deemed troubled by the FDIC. Among community banks that had increased their CRE loans to more than 30% of their total assets, the failure rate was more than 40%.

The study period covering the economic crisis in the late 1980s, 1990s and the interval starting in 2006 consistently reveals that a higher level of CRE and C&D lending was associated with higher rates of bank failure.

Community banks are defined to a substantial degree by geography. They have fewer banking offices, occupy smaller geographic areas and are more prevalent in rural areas. These rural areas where community banks hold a larger share of deposits have grown more slowly than the country as a whole, and in some cases even declined. While these economic and demographic challenges do not seem to be adversely affecting financial performance or leading to higher rates of consolidation, they have limited growth opportunities for community banks

The analysis of the efficiency ratio in the FDIC Community Banking Study also presents an opportunity to understand the reasons for declining community bank profitability. Since 1998, the efficiency gap between community and non-community banks has widened considerably, reaching a peak of 19.5% in 2009 before reducing to 9.7% in 2011.

The single biggest factor in the increase of the efficiency ratio has been the compression of the net interest margin. Since 1998, the ratio of net interest income to average assets has declined by 41 basis points, resulting in a 5.8% increase in the community bank efficiency ratio. This has also been a period of low interest rates and could have pushed community banks to look for risky yields in CRE and C&D loans.

The gradual erosion of the net interest income ratio in community banks and a compensatory shift toward adding risk to their balance sheet in search of additional yield via new lending strategies is a major factor responsible for high chargeoffs and community bank failures.

Even though regulation has increased over the past decade, it would be an oversimplification to attribute a reduced number of community banks and their lower profitability only to regulation.

Anshuman Sindhar is principal consultant at Capco, a business and technology consultancy.