After 93 years in business, Perpetual State Bank of Lexington, N.C., decided it just couldn't cut it anymore.

For Glenn Smith, the bank's chief executive, it came down to one of two choices: Make a huge investment in technology and product diversity or sell.

Mr. Smith chose the latter. In April he sold to a larger community institution in a nearby town.

"We just couldn't keep up," he said.

In the past decade, thousands of small banks like Mr. Smith's have reached the same crossroad and taken the same turn.

More than 5,400 banks have been merged out of existence since 1984. And close to 90% of those institutions have been community banks - institutions with assets of less than $1 billion.

In less than a generation, community banks - locally owned institutions that serve consumers and small and midsize businesses across the nation - have watched their status erode at the hands of larger banks, finance companies, and even mutual fund companies and brokerage firms.

It begs the question: What kind of future does community banking face?

In a two-part series beginning today, the American Banker explores where community banking has come from, and where it's heading. The series describes the forces that have led to the decline of the small independent bank over the past few decades and offers a blueprint for how resourceful banks can survive and even prosper.

The reasons for community banking's overall decline are many, according to bankers and industry experts. For starters, they say, many community banks have failed to address the changing financial needs of baby boomers.

These institutions have also been hampered by burdensome regulations and an inability to afford the high technology needed to compete. And they've seen some of their lending niches transformed into cheap commodities by securitization and the growth of the secondary market.

To be sure, some bankers question the premise that community banks will need to transform themselves in order to survive. After all, small bankers in recent years have trumpeted record earnings, and their continual growth has surpassed many observers' expectations. And community bankers tout their "high-touch" personal service as the hallmark of that success and the key to their viability.

Indeed, in the area of farm operating loans and farm mortgages, community banks have remained the dominant player, still surpassing not only large banks, but also government agencies and government-sponsored entities.

But those financial results belie community banks' diminishing influence overall in the national economy. A few sobering statistics based on data from the Federal Deposit Insurance Corp. and Federal Reserve Board help illustrate this point.

*Since 1984, total private-sector savings has more than doubled to $26 trillion, but community banking's share has fallen by half to more than 3% of the total.

*Community banks' share of commercial and industrial lending has dropped from 18% in 1984 to 9% in 1995, while larger institutions saw a jump in market share.

*And their share of home mortgages has dropped by 19% since 1984, while larger banks increased their share 79% and the total market more than doubled.

"The banking industry as a whole is getting a smaller share of the credit market, of both loans and deposits," said Sung Won Sohn, chief economist of Minneapolis-based Norwest Corp., "and the community banks are getting a smaller share of what banks have."

Bank executives are hardly ignorant of this trend.

"If I was running a small bank, say $100 million or so in assets, I'd look to sell it," said David Francisco, chief executive of Mid-Am Inc., a $1.5 billion Ohio banking company. "We're kidding ourselves if we think the only ones who can provide customers a 'relationship' is a community bank."

Small banks have also been bested by a host of nonbank challengers, including specialized financial companies and mutual fund firms. These new competitors have increased their share by as much as 200% in a decade, and mutual funds now have more than $3 trillion in assets, equal to total bank deposits.

"What took the banking industry 100 years to build only took the mutual fund industry a decade to match," said Donald McGowan, president and chief executive of Flagship Bank and Trust Co. in Worcester, Mass., a subsidiary of Chittenden Corp., Burlington, Vt.

In Hamilton, Ohio, for example, Home Federal Bank has watched its growth rate grind to a halt in the last five years, mostly because of increased competition from mutual funds and credit unions. In the 1970s and '80s, Home Federal had a 10% annual growth rate; now the rate is flat.

The thrift's local banking deposit market share has also dropped 20% in the same time period. And it's lost out on some loans to insurance companies and other nonbanks.

"Back in the '70s, we used to call that disintermediation," said Donald A.W. Patterson, Home Federal's chief executive. "Now we don't look at banks as intermediaries. There's too many other groups dispersing money throughout the country."

Unlike past generations, consumers today are far more sensitive to concerns about saving for the future, and far more aware of their financial alternatives. For example, mutual funds now even offer check-writing privileges against fund accounts.

"It's not so much the banks that have changed, it's the customers that have changed," Mr. Sohn said. "The banks have to follow the customers, and the customers have become a lot more sophisticated."

Instead, however, many small banks, especially in rural areas, are still focusing their marketing efforts on the older generation.

"They're relying on the customer base they have, which is generally an older base that is not going to seek the Charles Schwabs," said Jerry Verdi, president of Buffalo-based consultant Verdi Ryan & Associates, referring to the brokerage house.

And even if they want to adjust their strategy, many of these institutions simply cannot afford the marketing or technological resources that would allow them to meet their customers' changing financial needs.

"This personal service stuff is great, but the public wants more than that," said Harry V. Keefe, chairman of Keefe Managers, a well-known institutional investor in bank stocks. "My wife is very computer-oriented and she doesn't care about personal service."

Many people have also become much more familiar with the workings of the stock market and how to invest wisely.

"Thirty years ago, the average person was not an investor in the market in any way," said Robert Listfield, principal of A.T. Kearney in Boston. "You have a different generation of people who have grown up and technology has enabled them to access the market."

Said C. William Landefeld, president and chief executive of Citizens Savings Bank in Normal, Ill.,"Our customer base has been too well educated that there are alternative forms of investment on the deposit side."

On the lending side, deregulation, the development of securitization, commoditization, and the rise of the secondary market are to blame for community bank woes, observers agree.

By allowing nonbank firms to originate loans and sell them to investors without having bank deposits to back them up, securitization has enabled almost anyone to compete in the lending market, with fewer expenses than banks.

"Community banks have been shouldered aside by a variety of different financial services providers," said David M. Partridge, director of the financial institutions practice at Towers Perrin in San Francisco. "The bad news is there's more of them. The worse news is that these products are being offered and retailed by companies that are better at retailing than the community banks."

Much of the problem, small bankers say, is due to costly regulatory burdens and deposit insurance premiums, which prevent them from raising deposit rates much without compromising profitability. Fast-growing nonbank competitors are free of such burdens.

The regulations have even discouraged some community bankers from entering new lines of business. By the time they decide to start offering the product, consumers no longer consider them a market player.

"You wind up with banks becoming less and less significant and regulators having less control over banking business because less and less of it is in the banks," said William M. Isaac, chairman of the Secura Group, a Washington-based consulting firm, and former chairman of the FDIC.

What does it all mean for the nation's 9,000 community banks? Bankers and analysts agree that community banks' market share is likely to continue to decline somewhat, but not as rapidly as before. That's in part because the consolidation wave is likely to be more concentrated in the future among larger institutions, they say.

Nevertheless, these trends are causing many small banks and thrifts to reexamine their entire strategy for the future.

For some, the key is to turn their attention away from less profitable consumer lending and home mortgages in favor of focusing more exclusively on their remaining small-business niche.

Others still hope to be general providers of services to their customers, relying not only on personal service, but also on new technology to equalize the playing field with myriad rivals.

"Is community banking a good franchise? Absolutely," Mr. Partridge said. "Will community banks be relevant, important, and useful five or 10 years from now? Absolutely. Must they change how they do business to get there and be around? Absolutely."

Tomorrow: Strategies for survival

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