Big-bank stock investing may be in a funk, and for clear reasons, but community banks still look like a good stock bet and look better equipped than the bigger ones for any downturn in the economy.

One factor in big banks' slump on the Street is the end of the merger-and-acquisition craze. There's less incentive to own bank stocks, because except in a few rare cases buyers have stopped paying three or four times book value.

Investors also worry that rising interest rates will weaken credit quality at a time when many feel that borrowers are already overextended. There's an axiom that says the best loans are made in the worst of times and the worst ones are made in the best of times.

Many observers say the big reason bank stocks are in the doldrums is simple: The industry has not learned from the mistakes of the late 1980s and early 1990s .

But should investors steer clear of community bank stocks?

Most community banks' loans make are not that sensitive to interest rate movements in the economy as a whole. Mr. Greenspan's every utterance means far less to the local bank's customers than it does to those of larger banks.

Similarly, leverage does not play a major role in the financial structure of most community bank borrowers.

So, as I see it, the only community banks that are likely to get into serious trouble when and if the economy weakens will be those that have lowered their standards in order to meet growth objectives.

The key to be remembered is that there is a limit to the growth a bank can have. If the money supply grows only 15%, a bank's deposits normally cannot grow more than 15 percent unless it woos accounts from other banks - a difficult job in an industry so loaded with customer inertia. Efforts to grow faster can be successful if a bank develops new, fee-related services, but that's no easy feat in this competitive market.

The only other route is to take on lower-quality loans or lend to borrowers who are outside the home territory, where they cannot be properly monitored.

But if a community bank realizes these limits to its growth and is willing to accept them - even if it means not matching the leaders on rates and terms - then community bank stocks should remain sound investments.

All that said, community banks must not become complacent. If the high-flying economy does have a rough landing, the consequences could be rough for community banks.

For example, high-quality borrowers could be affected by a downturn in the securities markets.

Housing may seem strong now, but people might not be able to continue paying today's unbelievably high rates for rentals and high prices for homes in a slow economy.

What community bankers must remember, basically, is the concept of covariant risk. This means that borrowers who at first appear to be without risk will feel the aftershocks of a decline in the fortunes of industries and companies that are more risky on the surface.

A rising tide raises all boats, and a declining tide lowers them all. But a change in the economy's tide probably will have less-drastic implications for community banks than for their bigger brethren.

Mr. Nadler, an American Banker contributing editor, is a professor of finance at Rutgers University Graduate School of Management in Newark, N.J.

Send Us Your IdeasMr. Nadler's column is a forum for community bankers to share their concerns, problems and solutions. You can participate by writing to:

Paul S. Nadler
14 Friar Tuck Circle
Summit, NJ 07901

Or you can fax to: 908-273-7309
Responses will be printed in the column.

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