Fed Reveals Secret Lessons of Successful Small Banks

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It's hard to believe but true: more than 700 banks maintained a pristine Camels 1 rating throughout the six-year period bracketing the financial crisis.

There was no cookie-cutter formula for avoiding a performance downgrade from 2006 through 2011. In fact, some of these banks did things you wouldn't expect of high performers like operating close to capital minimums or blowing past regulatory limits on asset concentrations.

But while success found many paths, research conducted by the Federal Reserve Bank of St. Louis did reveal a common trait among these banks — they all have top-notch managers who know their markets.

"The guys that we talked to could run a good bank just about anywhere," says Andy Meyer, a senior economist at the St. Louis Fed. "They each found some way to serve their community. There clearly was no one-size-fits-all model."

Among the more surprising findings were the study's insights on size.

For years, experts have predicted a wave of consolidation among community banks and insisted that banks would need at least $1 billion of assets to compete.

But the St. Louis Fed's research shows that the asset range with the most "thrivers" — the term it used to describe these remarkable banks — was $100 million to $300 million (See Table 1 here.)

Thirty-eight percent of the thrivers were in that range. The next asset category with the greatest number of these banks was even smaller — $50 million to $100 million. Just over 22% of the "thrivers" were that size.

Only 36 banks of these 702 banks had more than $1 billion of assets.

Texas had the most thrivers by far, with 124. Iowa and Oklahoma were second and third, with 66 and 65, respectively. The St. Louis Fed attributed this to robust energy and agriculture markets. Just nine states accounted for 73% of these banks.

Still, the St. Louis Fed found thrivers in 40 of the 50 states, including some states hard hit by the recession like Michigan and Ohio.

Some other interesting tidbits: thrivers did not have high loan-to-asset ratios, which led in turn to relatively low levels of interest income and interest expense. Most had low operating expenses as well.

They tended to have high capital ratios, but some did operate near regulatory minimums. These banks were able to maintain a Camels 1 rating because they took on so little credit risk, the St. Louis Fed said.

Of the 702 banks, 16% had commercial real estate concentrations that exceeded the federal guideline of 300% of risk-based capital. "These observations indicate that the thriving banks as a group did not avoid the problems of other banks through relatively low exposures to CRE," the report concludes. "Instead these thriving banks were able to successfully manage the risk inherent in CRE lending."

The St. Louis Fed researchers decided a couple years ago that they wanted to know what separates a good bank from a great one.

Much of the research stemming from the crisis focused on the mistakes banks had made, so the St. Louis Fed decided to take the opposite approach. They went in search of the banks that managed to keep a Camels 1 rating for the six years stretching from 2006 through 2011. Meyer says in an interview that they were surprised to find 702 of them, or 13% of the banks in their study. [The research covered banks with $10 billion of assets or less that were in business before 2001 and survived the crisis.] St. Louis Fed analyzed these 702 banks on everything from asset quality to expense control to interest income to gain some quantitative feel for their operations. Then they turned to interviews to get the qualitative piece. The bankers interviewed were dispersed geographically, employed varying types of bank charters and represented every size on the asset spectrum.

In all, 28 bankers sat down to answer the St. Louis Fed's questions about how they were able to ace what can only be described as a real-world stress test: the financial crisis.

"Bankers told us, 'The reason we did well wasn't because of any actions we took during the crisis. It was the policies and procedures we had in place before the crisis and we did not vary from those,' " Meyer says. "They made a point of not just jumping from one hot market to another hot market."

Meyer and his co-authors at the St. Louis Fed, Jim Fuchs, an assistant vice president, and Alton Gilbert, a visiting scholar and economist emeritus, are doing more research on banks that were downgraded to a Camels 4 or 5 during the crisis and then upgraded to a Camels 1 or 2.

There are 145 of these banks, including five that made it all the way back up to a Camels 1 rating. "We really want to look at those," Meyer says. "How many did it with totally new management or by merging with another bank? There are a lot of questions we can ask about banks that recover that much."

This research is part of a broader effort at the St. Louis Fed, which plans to co-host a conference in October on the future of community banking with the Conference of State Bank Supervisors. Fed Chairman Ben Bernanke is already confirmed as the keynote speaker.

Julie Stackhouse, the head of supervision at the St. Louis Fed, says the goal of the conference is to generate more interest in research on community banking. The St. Louis Fed's request for papers includes topics like the role that community banks play in the financial system, their importance to the communities they serve and the challenges that community banks face in the current business and regulatory environment.

In the months leading up to the conference, state banking commissioners are meeting with bankers to discuss a series of questions posed by the St. Louis Fed. The questions cover everything from the importance of scale to the challenges of nonbank competitors. "We are really trying to pick the brains of bankers about how they see the future of community banking," she says.

Stackhouse says state regulators will forward dominant themes to the St. Louis Fed, which will incorporate them into the conference.

"I am not fearful of the loss of the community banking model," she says. "I think there will be fewer, the question is how many fewer?"

The key, she says, is identifying and offering the products and services that customers want, which may be a tall order for community banks competing with much larger companies in urban and suburban markets.

Stackhouse loops back to one element uniting all the thrivers — great management, and says executives will need to "be a real leader, maybe a bit of a visionary, certainly a strategist."

Barb Rehm is American Banker's editor at large. She welcomes feedback to her column at Barbara.Rehm@SourceMedia.com. Follow her on Twitter at @barbrehm.

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