While now is hardly the time for optimistic forecasts, next year could present community banks with unprecedented opportunities to add customers, loans, and talent as larger rivals repair balance sheets and integrate mergers.
The $4 billion-asset Taylor Capital Group Inc. in Rosemont, Ill., is a case in point. The parent of Cole Taylor Bank added $287 million of commercial loans in the third quarter, and picked up 50 bankers from LaSalle Bank Corp. after ABN Amro Holding NV sold the unit last year to Bank of America Corp.
"Since the beginning of this year, we've had one of the most substantial periods of growth we've ever experienced," said Bruce W. Taylor, Taylor Capital's chairman and chief executive officer.
Mark Fitzgibbon, the head of research at Sandler O'Neill & Partners LP, said many smaller banking companies are well positioned to take advantage of market disruption by beefing up their staffs and entering into new lines of business. They also can capitalize on customer runoff, and the strongest ones are even scouting for branches or banks to buy.
"The turmoil will be really good for the little guy," Mr. Fitzgibbon said.
Bart Narter, senior vice president of the banking group at Celent in Boston, agreed.
"They have money to lend, and I think they'll be able to grab a lot more small, and maybe even midsize, businesses," he said.
Still, caution rules. Many bankers worry that a deeper recession could undermine even the best borrowers, and say they need to be extra vigilant in their underwriting.
They also say they will need to become more technologically sophisticated, if only to satisfy the business customers defecting from large competitors.
More broadly, questions fester about the changes a regulatory shake-up might bring and the consequences of extraordinary government intervention to prop up the industry. Some say shifting deposits are a particular danger for community banks over the longer stretch, as the public perceives large banks to be safer because regulators are reluctant to let them fail.
Community banks are hardly immune to the crisis. Nearly two dozen have collapsed this year and many more have been badly hobbled by losses on loans to real estate developers. Taylor Capital lost more than $54 million in the third quarter as nonperformers and chargeoffs spiked.
But Taylor was seen as healthy enough to receive a $105 million capital infusion from the government (to go along with $120 million it recently raised on its own) that it intends to use to expand market share in the Chicago area.
Smaller banks could also be looking to pick up branches that larger banks might be divesting. Several community banking companies in western Pennsylvania are expected to bid on the 61 branches PNC Financial Services Group Inc. in Pittsburgh is divesting as a condition of its deal to buy National City Corp. of Cleveland.
Ellen Seidman, the director of New America Foundation's Financial Services and Education project and a former director of the Office of Thrift Supervision, said the market upheaval could ultimately benefit small banks because they tend to be closer to their customers.
"I think we're clearly going to go through a period now where there is going to be a much greater portion of the population who will be more difficult to underwrite," she said. "Community bankers and their counterparts in credit unions and community development financial institutions are the ones who really can sit down and work with consumers and small businesses to underwrite them well."
Therein lies a challenge, too. As the economy deteriorates further, underwriting will get trickier.
But most community banks are in better shape to weather the downturn than larger ones.
In good times and bad, the most profitable banks are those with assets of $1 billion to $10 billion, according to an analysis by Celent, a consulting unit of Marsh & McLennan Cos.
Those banks had the highest return on assets from 2003 through June of this year, the period covered in a study Celent released Thursday. Only in 2006 did larger banks match their results.
Celent's Mr. Narter concluded that the larger banks have "inferior risk management" — they consistently price their loans lower and end up charging off more of them.
For the past five years, banks with over $10 billion of assets had the lowest yield on earning assets and the highest ratios of net chargeoffs to loans, the Celent data indicates. In the first half they had a yield of 5.84%, versus 6.48% for banks with $1 billion to $10 billion of assets, and a chargeoff ratio of 1.25%, versus 0.87%.
Many community bankers say their yields are improving lately, too.
"The fact that we're no longer competing with Wall Street and its ability to buy, package, and sell assets has been one of the factors that has improved margins in our business," Mr. Taylor said.
Commercial and industrial loans that would have been priced at 100 basis points over the London interbank offered rate six months ago are being priced at 225 over now, Mr. Taylor said. For commercial real estate loans, the increase is even higher.
"We're getting better pricing on the relationships we're bringing in today than we have in many, many years," he said. "Customers are less price-sensitive and very focused on the availability of credit."
One category that illustrates both the growing opportunities and challenges for community banks is commercial real estate loans under $5 million, said Randy Fuchs, a principal at Boxwood Means Inc. in Stamford, Conn. His research and consulting firm tracks these loans, which are often made to small businesses.
Lending for the second quarter spiked 49% from the first quarter, to $36.9 billion, ending four consecutive quarters of declining volume, according to the Boxwood Means data. (The third-quarter data is still being compiled.)
But collectively the 100 companies that had done the most small CRE loans in the previous year — which include the country's banking behemoths — lost market share. Even though a few defied the trend, the market share for the group slipped by a combined 2.8%, giving up that ground to smaller banks, the data shows.
"One of the interesting things to me is that, with all of the dialogue out there about how frozen the lending markets are, under the radar smaller local and regional banks are doing business," Mr. Fuchs said. "They are picking up some of the slack for a number of bigger banks that remain sidelined."
The overall shifts in market share underscore "a potentially dramatic redirection in future customer relationships" toward smaller banks, Mr. Fuchs said.
"From a historical standpoint, this is really a major change," Mr. Fuchs said. "It's an unprecedented opportunity for community banks."
With competition lacking, not only are small banks seeing more deals, they are getting better-quality loans, he said. The banks can get higher rates and be choosier about borrowers and collateral.
"But the opportunity comes with some caveats," Mr. Fuchs said. Commercial real estate market fundamentals are sliding in almost every area of the country. Though community banks are generally conservative, they must be more so now and exercise more due diligence.
One alarming trend is that three out of four loans in the second quarter were refinancings, with many of those borrowers taking cash out, according to Boxwood Means. "Our concern is that this is a sign of added stress in the market," Mr. Fuchs said. "It showed some desperation on the part of these small-business owners. Because the economy was starting to get worse, they were starting to use their commercial property to generate some more cash flow for their business needs."
Mr. Fuchs also warned against complacency about the customer wins. Used to dealing with big banks, these savvy borrowers come with high expectations about loan turnaround times and execution.
"There's a window here. Eventually these other lenders will come back," Mr. Fuchs said. "One of the challenges for these smaller banks is to get more sophisticated," so they can retain the borrowers even after other options become available once again.
Others also said many community banks must sharpen their technology to survive.
Several consultants and analysts agreed that community banks must wean themselves from a reliance on commercial restate for growth and said the chance to pursue commercial and industrial lending and fee businesses such as wealth management has never been better.
Besides credit quality, deposits could be a vulnerable front for community banks.
Jeff Merwin, director of retail banking for the $4 billion-asset Riverside National Bank in Fort Pierce, Fla., said he thinks the way customer relationships are created is changing. Previously being a lender preceded being a deposit holder, but that emphasis has switched.
His bank, which targets businesses with revenue of $50,000 to $250,000, has an "Every Penny Counts" program to foster saving. Similar to Bank of America's "Keep the Change," it rounds check card purchases up to the nearest dollar and deposits the change in a savings account.
By showing it has all the sophistication of a large bank, Riverside hopes to build deposit relationships with retail and small businesses, Mr. Merwin said. "That will eventually lead to loans," he said.
For now banks of all sizes are gaining deposits, but the pace of that growth at community banks lags far behind the large banks.
In the third quarter core deposits for the overall banking industry grew 14% from a year earlier, to $5.8 trillion. And in general the larger the institution, the greater its share of those deposit gains. Deposits rose 16.7% at institutions with more than $20 billion of assets; 14.1% at those with $10 billion to $20 billion of assets; 10.5% at those with $1 billion to $10 billion of assets; and 8.6% at those with less than $1 billion.
Some say that by confirming in the public's view the perception that a few big banks are more important than the rest, regulators put smaller banks at a disadvantage, however inadvertently.
"This period has proved there is something to being 'too big to fail,' and that competitive inequity is going to have to be dealt with in some way," Mr. Taylor said. "It's obvious most community banks would not fit into that category, but a handful of the largest institutions do. So at a time like this, when people have a strong aversion to risk, you find a lot of deposits migrating quickly."
