Over the last 10 years, the number of freestanding banks in the U.S. has been cut in half, to roughly 7,000. The Federal Reserve predicts this total will shrink by half again in the next five to 10 years.

Clearly something big is going on, not only among big banks but also among the thousands of community institutions that hold most of the charters around the country.

Bankers must be thinking about the future. Must you merge? Should you buy another bank? Is it time to sell?

In my opinion, the answer to each of these questions depends on how you define your business going forward.

For many years, community banks have felt secure because they thought they knew their customers and believed that their customers both knew and liked them. As big banks have consolidated and become larger factors in smaller markets, local institutions have relied on their sheer local-ness as a prime competitive weapon.

However, a quick look down Main Street in most small towns suggests the fragility of this defense. Customers may know, and even like, local hardware stores or groceries, but they will go to big providers like Wal- Mart or Safeway to save a buck or two. Most consumers seem to think that they have plenty of friends at home and thus do not need to select a bank simply on the basis of its ability to recognize them when they walk in the door.

How, then, to think about a community bank's comparative advantage?

Financial products fall into three broad categories: utility, commodity, and value-added. Though some products overlap in these categories and others are moving from one to another, these basic descriptions lay the groundwork for a rigorous analysis of what a company is likely to be good at as it expands or redefines its business.

The goal of the product models outlined here is to identify what it takes to be good at different aspects of the banking business. Once that is done, companies can emphasize what they are good at, rather than swimming upstream into product lines in which they are not likely to succeed.

Here is a quick review of each financial product category:

A utility product is one that is little differentiated from provider to provider. A checking account or CD are good examples. These products vary little from bank to bank and are usually sold on the basis of convenience or marketing premiums (free services, toasters, etc.), not genuine differences in the product itself.

In general, utility products are those that individual and corporate customers have to have for ordinary financial activities, rather than those they want to acquire for specific personal or professional goals.

Successful providers of utility financial products must have large front-end distribution systems and effective marketing capability, usually with a solid "brand" name. They also have to have a large back room, because these products generally require extensive systems and servicing backup. These products also generally require a major commitment to regulatory compliance and bear a heavy capital cost. Importantly, they are the segment of the industry experiencing the most profit pressure.

Commodity products are similar to utility ones because they too are little differentiated among providers. Conventional mortgages and credit cards are the best examples of a well-developed commodity financial product.

However, convenience is not generally a meaningful factor in determining buying behavior for these products; marketing through relatively novel channels is clearly far more important. Risk management is crucial to success, but capital is not as important because most asset products delivered through the commodity model are quickly securitized. A big back office is essential in commodity products to ensure true uniformity, compliance with underwriting standards, and effective delivery through nontraditional channels.

With value-added products the ability to deliver differentiated products to different customers is crucial, requiring extensive sales and servicing capability. Examples: private banking, commercial lending (other than small-business), real estate agency, financial planning. Convenience is important for some services, but others can be delivered through alternative channels that range from personal visits to on-line systems.

As this brief outline suggests, traditional banking products tend to fall mostly in the utility and commodity categories. This suggests strongly that community banks that stick to the traditional model will find themselves under heavy profit pressure.

Utility products are producing declining margins, and it is difficult to achieve significant operating efficiencies in this category. Small banks simply lack the systems and delivery skills and technology likely to achieve successful commodity delivery, though banks can be integrated into the delivery channels for other providers, taking fees for customers delivered.

The categories described above, along with the skills necessary for success in them, have been only briefly outlined. The goal here is simply to lay out a framework for thinking about comparative advantage, not to define it precisely for each bank or financial services firm. Nevertheless, the outline does convey the following clear message: Community banks have a real edge in providing value-added services, and many of the most interesting of these are nontraditional products for many banks.

The merger lesson from this analysis is that combinations of traditional community banks will likely result in too much of a not particularly good thing-that is, increased investment in utility product capability where margins are shrinking and big bank competition is increasingly formidable.

In contrast, expanding into value-added products offers a way for community banks to do more of what they are already good at: serving defined customer bases with specific products tailored to individual needs.

Expansion here through merger implies acquisition of nontraditional firms-local real estate agents or tax-preparation services, for example. In some cases, these acquisitions may break new regulatory ground. However, recent actions by both the Office of the Comptroller of the Currency and the Federal Reserve make clear that many nontraditional opportunities are already possible under existing regulations-let alone what the agencies are contemplating or Congress may be considering.

Large banks are busily combining to capture the acquisition premiums the market has paid into many of their share values. The wisdom or folly of these combinations will be clear only after they are road-tested, but some do appear to be premised on questionable long-term expectations of operating efficiencies and revenue growth.

Smaller banks, though, face a different challenge because their stocks are not widely traded and management is more closely aligned with ownership. Selling the bank to get the pop in the stock price and then moving on to a new job is not the goal of many small-town bank CEOs or their boards. Instead, they look to ways to continue the tradition of providing financial services to local communities and making a dime or two doing it.

If your bank plans to stay a bank and you want to be a banker, then you should probably sell. The old bank model will not be a successful one for most small banks as the industry consolidates and economic conditions become less forgiving.

If, however, your goal is to run a successful local financial services business, then you may want to consider buying, not selling-and buying other types of businesses, not other banks.

This may seem like a radical recommendation, but I think it is actually quite conservative. Most community banks were built by entrepreneurs with a vision of providing financial services to their neighbors. Over the years, community banking has been bogged down in a far less dynamic approach, leading to complacency and, now, to consolidation. In many ways, though, the future of community banking lies in its past.

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