Is There a Future for Midsize Banks?

I have a running debate with one of my colleagues about the viability of midsize banks. Neither of us believes the current merger wave presents much of threat to the small community banks, assuming they are well run. Where we part company is with respect to the banks that are too big to be small and too small to be big.

Let's begin with our areas of agreement. The merger wave among the nation's largest banks, now well under way, will continue. A handful, say 20 or so, of mass retailers of financial services will operate in major markets throughout the nation. They will be efficient, low-cost providers of financial services, and they will offer the latest in sophisticated technology.

Smaller Banks Can Survive

At the other end of the spectrum, a few thousand community banks will remain. They will exist primarily in smaller communities where the megabanks can't generate enough mass to give them a competitive edge.

They will also be able to compete successfully in the major markets by offering high-quality, personalized services that the largest banks can't match. Responsiveness, not price or technology, will be their edge.

There's no small amount of irony in the fact that almost no one disagrees with this forecast of a bright future for community banks except their supposed champion, the Independent Bankers Association.

In Control of Destiny

A few hundred midsize banks now operate in markets such as Milwaukee, Indianapolis, and St. Louis. My colleague believes their long-term prospects for survival as independent entities are dim. I believe their destiny is in their own hands.

My colleague's premise is that the megabanks will become so efficient and will offer such high-quality service that the midsize banks will not be able to compete against them. Even if the midsize banks are good at what they do, the megabanks will be able to underprice them. Moreover, the megabanks will enjoy such high price-earnings ratio they will be able to make takeover offers the midsize banks can't refuse.

My view is that banking will continue to be a relationship business and that having a strong physical presence in the community will continue to provide an enormous competitive edge that cannot be overcome by a bank that doesn't have it. The megabanks can buy some relationships, but not those (the so-called middle-market customers) that banks most covet.

Underpricing the Hazards

Experience has shown that banks that attempt to buy relationships inevitably underprice the risks they are taking and incur enormous losses against which they are not properly reserved. Moreover, uniform regulatory capital requirements have diminished the incentive to add marginal business.

As for offers that can't be refused, I'm not convinced we will see many of them. A bank with a high stock multiple might be able to put into play one of its less fortunate brethren, but it can't guarantee it will be the successful acquirer. Stock will almost always be the currency used in a takeover of size, and the board of the target company has a great deal of discretion in deciding which company's stock it wishes to accept. As the barriers to geographic expansion come tumbling down, there will be many more alternatives from which the target may select.

A Commonplace Debate

The debate my colleague and I are having is being echoed in executive suites and board rooms throughout the country, as banks plan their strategies. The outcome of the debate is profoundly important. For if the midsize banks conclude they don't have a place in the evolving banking world, they will sell out.

I think that would be unfortunate. It's not that I'm opposed to substantial consolidation within the banking industry. To the contrary, I believe consolidation is necessary to weed out marginal competitors, eliminate the industry's excess capacity, and enable banks to achieve greater geographic diversification in their loan portfolios.

What I don't favor is unnecessary consolidation. Banks that are properly serving their communities, are earning a decent return for their shareholders, and have a management team and business plan to carry them forward should not rush into the arms of an acquirer.

It would be a mistake to underestimate the risks in selling out. A decision to sell should be taken at the right time for the right reasons.

Mr. Isaac, a former chairman of the Federal Deposit Insurance Corp., is managing director and chief executive of the Secura Group, a Washington-based financial services consulting firm.

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