The Bell Tolls for Community Banks — Unless the FDIC Acts

First of two parts.

The Federal Deposit Insurance Corp. declared that the "projected decline of the community banks sector … is significantly overstated" in its quarterly publication on April 9th. Absent concrete changes in the operating environment in which community banks compete, the FDIC's prediction will likely prove wrong over the next few years. Possibly profoundly wrong.

The facts challenge the FDIC's optimism. Since the beginning of 2010, the number of banks in the U.S. has already declined by 15%. (By comparison, the number of U.S. banks fell by 20% in the 1980s, 36% in the 1990s, and 22% between 2000 and 2009.)

If the banking crisis of the 1980s and early 1990s is our guide, the industry should expect merger activity to spike to 20-year highs between 2014 and 2018 — further diminishing the number of community banks left standing.

The 1990s taught the banking industry that the pace of mergers generally accelerates when balance sheets mend and stock prices recover. In fact, the period between 1994 to 1998 — the aftermath of nearly 3,000 bank and thrift failures during the banking crisis — witnessed the fastest pace of unassisted bank mergers in recent history. For five consecutive years, the number of banks in the U.S. declined by at least 5% per year because of mergers. If not for new bank charters, those percentages would have been much higher. By comparison, unassisted mergers eliminated just 3.3% of U.S. banks in in 2013.

A combination of factors accelerated merger activity in the mid-1990s. Many of these same dynamics exist today, including disheartened bank directors, aging bank chiefs, rapidly advancing technology and increased regulatory burdens.

In the 1990s, many bank directors were worn out. The banking crises of the 1980s and early 1990s had stressed bank earnings and stock prices. This deterioration took a toll on directors. As banks healed, many directors jumped on opportunities to sell their banks for book value or better.

An aging population of chief executives also played a part in bank merger decisions of the 1990s. Many CEOs had been hired back in the 1950s, when banking operated much like a cartel because of laws that blocked lenders from participating in free market activities like paying interest for demand deposits. Some older executives simply did not want to compete in the new and uncertain world ushered in by the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, which required banks to compete against ambitious banks intent on building coast-to-coast branch networks.

Technology, especially the emergence of online banking, required banks to invest in next-generation delivery systems and products. Rather than invest in an unfamiliar area, some banks preferred to merge with lenders that claimed to have a vision for the future.

Regulatory burdens had an incalculable influence on merger decisions. In the wake of so many bank failures, the regulator headcount ballooned to record numbers by the early 1990s. With more personnel came more supervision. In addition, some bankers worried about increased compliance costs stemming from the expansion of the Community Reinvestment Act during the 1990s.

A final factor behind the rush of mergers in the 1990s was banks' desire to better manage scale and expenses. Many lenders sought to control these variables in pursuit of profit growth and higher capital. Mergers delivered them with an opportunity to focus on both.

Today, scale and expense concerns are arguably even more pressing issues than they were 20 years ago. As the FDIC acknowledged in its quarterly report, scale is among the leading reasons that banks merge. However, the FDIC did not mention its own data revealing that the bigger banks' efficiency ratio advantage has widened materially since the '90s, suggesting that bank size is highly correlated to profitability.

During the decade of the 1990s, banks with over $10 billion in assets had a mere 100 basis-point advantage in efficiency ratio compared to banks with asset sizes between $100 million and $1 billion. Compared to banks under $100 million in assets, the advantage was greater at 400 basis points. During the past four years, the gap between larger and smaller banks has widened to 1200 basis points and 1900 basis points, respectively.

Data on average assets per employee tells a similar story of disparate scales. Since January 2010, the bigger banks have nearly twice (87%) the assets per employee than the 4,090 community banks with assets between $100 million and $1 billion. The gap between bigger banks and the 2,056 banks with under $100 million in assets is more than double (119%). The trends suggest that these disparities will keep getting bigger.

If the FDIC wants to stall bank consolidation, it needs to enter into discussions about how to produce substantial legislative and regulatory changes that alter the operating environments in which smaller community banks compete. This will be the topic of my next post on BankThink.

Richard J. Parsons is the author of "Broke: America's Banking System — Common Sense Ideas to Fix Banking in America," published in 2013 by the Risk Management Association. He worked for 31 years at Bank of America.