It has been common wisdom and a revered tradition that small banks are more profitable than big banks.

The reasons are apparent. Small banks are deemed to operate at wider margins, a function of low-cost funding and price elasticity among loyal customers.

Small banks are also assumed to know their customers in a way that big banks cannot, and therefore to have better and more consistent credit quality.

While both assumptions were true in the past, the reality is different today. Large banks are now more profitable than small banks, in terms of return on assets and return on equity, for the first time ever. Community and super community banks must take note of this change in the fundamentals of the business and rise to the challenge.

Finexc Group and Keefe, Bruyette & Woods Inc. recently studied the underlying causes for this dramatic shift in bank profitability.

We looked at banks with under $5 billion in assets and over $5 billion in assets, then developed medium performance histories for these groups from 1983 through the first quarter of 1994.

What we found was that banks with over $5 billion in assets have been more profitable than the smaller group since 1991, when they earned 0.86% on assets compared with 0.72% for the smaller banks.

While both groups' performance has improved since then, big banks maintained their performance edge, with a 1.22% return on assets in the first quarter of 1994, versus only 1.06% for the smaller banks, and 15.6% and 12.1%, respectively, for return on equity.

The reasons for the large banks' better performance are associated with improved management of the fundamentals, as well as the decline of the credit quality advantage which smaller banks enjoyed for so long, reflecting the improvement in the national economy.

Bank performance is a function of four factors: net interest margins, overhead, fee income levels, and credit costs. Large banks' performance has improved in all categories. In fact, the only area where both groups performed equally dismally is fee income.

In 1983 the typical large bank's fee income accounted for 25.2% of its operating income. In the first quarter of 1994 the figure was only 26.4%. Smaller banks show equally poor performance starting at 18.9% in 1983 and rising only to 20% in 1994.

The flip side of the coin is that net interest margin is the major determinant of bank profitability, then and now. Traditionally, small banks had a 30- to 40-basis-point advantage over large banks. But that is no longer true.

Large banks' net interest margins have risen during the period (4.40% today, versus 4.27% in 1983), while small banks have experienced a deterioration of this most important earning determinant (4.38% today, versus 4.77%).

Earning assets yielded the same levels for both large and small banks, then and now (asset quality for large banks has improved dramatically during the period). It is in the cost of funds where big banks have made tremendous strides.

Between 1983 and 1990, small banks' funding costs were 10 to 44 basis points lower than those of big banks. Today the picture has flipped due to large banks' reduced dependence on purchased funds and small banks' increasing dependence on interest-bearing liabilities.

Larger banks are less dependent on costly purchased funds as a result of the structural changes in the industry, including a reduction in excess capacity resulting from in-market mergers and the large banks' absorption of failed thrift franchises, which have enhanced large banks' pricing power over core deposits.

At the same time, small banks have experienced a long-term erosion in interest-free demand deposit funding. Large banks have experienced the same trend, but they have offset it to a large extent by improving their capital accounts, replacing interest-free external funds with interest-free internal funds.

While margin parity is a major contributor to closing the gap between the relative profit performances of large and small banks, superior efficiency ratios have given larger banks an edge that we expect to become even more critical.

While large banks were generally less efficient than smaller banks throughout the eighties, by 1990 both groups were tied with 64.4% efficiency ratio.

Since then large banks have improved to 62.1%, while smaller banks have marginally improved to 63.8%. As competitive pressures on both assets and liability prices intensify, a competitive cost structure has become more critical to profitability.

Another major change is the improved asset quality of large banks, to the point where differences in credit costs are nearly non-existent.

Today loan-loss provisions plus foreclosed property expense accounted for 4.5% of operating revenues of large banks, versus 4.0% at smaller banks. This is much different from the early '80s when large banks typically lost 7% to 9% of operating revenues to credit costs against 5% to 6% for small banks.

The reason, in part, is the shift in large banks' portfolio mix. Today large banks are as consumer oriented as smaller banks.

In the first quarter of 1994, consumer lending, including residential mortgages, represented 49.5% of the typical large bank's total portfolio, versus 49.8% at the typical small bank.

Only four years earlier the figures were 39.3% and 46.9%. As portfolio composition differentials become more muted, so we suspect will differences in the credit experience.

Although big bank loan losses still markedly exceed those of community banks, the differential has narrowed in the past couple of years, a reflection of improved economy and portfolio shifts.

Large bank net chargeoffs (0.31 % of average loans, versus 0.23% for small banks in the first quarter of 1994) are now lower than the 0.40% small banks experienced in the preceding decade.

The median large bank's nonperforming asset ratio (1.25% today) is now lower than that of the typical small bank (2.10%), possibly a reflection of improved credit scoring and other technical tools that large banks have better access to.

Last, reserve coverage of problem loans (207%) is stronger than the small banks' coverage (135%). Big banks' better showing on these two measures is a phenomenon that has been in evidence since 1992.

Banks, both large and small, obviously benefit from the current stage of the credit cycle, and portfolio quality throughout the industry will surely deteriorate with the next recession, as it did with the last.

We do not mean to suggest otherwise. What we do suggest, however, is that large banks with their stronger earnings and credit profiles, are more competitive than ever and may be able to weather the next crunch better than smaller institutions.

Community and super community banks need to recognize the challenge posed by superior larger bank performance and come to grips with its implications to their own survival and prosperity. Ms. Bird is chairman and CEO of Finexc Group LLC, and Mr. Berry is director of research at Keefe, Bruyette & Woods Inc., New York. For the first time, large banks are ahead in profitability.

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