The chatter about community banking these days—in the press, in political circles and even among bankers themselves—is that it is an industry in peril. Hamstrung by problem loans and too small to access the capital markets, countless community banks that not long ago had growth ambitions are shrinking their balance sheets in order to preserve capital.

While it's true many small banks are struggling to remain relevant, others are thriving, like First Virginia Community Bank. The $275 million-asset bank in McLean earned a record $2 million last year and grew its loan portfolio by nearly 30 percent—organically—at a time when loan demand is supposedly weak. Founder and CEO David Pijor says much of the growth has come at the expense of larger rivals that have become increasingly inflexible.

His four-year-old bank has not yet tapped the capital markets, but it raised $36 million from local investors and customers and has a waiting list of people ready to pony up next time it needs capital. Pijor says he has every intention of pursuing a public offering within a few years and has no doubt the bank will reach $1 billion of assets soon thereafter.

"We are very keen on community banking," Pijor says. "We see the chaos and uncertainty in the marketplace, and see it as a real opportunity to have a dialogue with potential customers about what we can offer. Business clients in particular realize that bigger is not better and, in fact, smaller and responsive is better."

It's tempting to attribute First Virginia's success to the fact that it operates in the Washington, D.C., suburbs, one of the nation's strongest banking markets. But even in hard-hit regions, like South Florida, many bankers are brimming with optimism. Charles Brown, CEO at the $145 million-asset Insignia Bank in Sarasota, says community banks are starting to win back mortgage-lending business that they had ceded to larger banks years ago. Insignia, primarily a business bank, recently lured a team of mortgage bankers away from a much larger rival, and Brown is eyeing more hires as a way to grow market share.

The challenges facing community banks are by no means easily dismissed. All have been contending with a significant squeeze from new regulations that simultaneously undermine revenue and inflate compliance costs-with the strain getting disproportionately larger the smaller the bank is.

"Dealing with regulation and compliance used to be 2 to 3 percent of a CEO's job. Now it's 15 percent at least," says Christopher Annas, chairman and CEO of Meridian Bank, in Devon, Pa. That's time the CEO can't spend wooing clients or devising strategy.

Then there's the ever-present threat from the big banks. Bank of America, JPMorgan Chase, Huntington Bancshares and others are ramping up small-business lending—community banks' bread and butter—with scores of new hires in recent months.

Community banks have no chance of competing with large banks on marketing. "Our biggest competitor is [the $25 billion-asset] First Tennessee, and they'll spend more on marketing in a year than we'll make in 10 years," says McCall Wilson, president and CEO at the $308 million-asset Bank of Fayette County in Moscow, Tenn.

Still, with every challenge comes opportunity, and there's a growing contingent in the industry that argues the competitive landscape is tilting in small banks' favor. Deposits are flooding community banks as larger competitors impose new fees and shutter branches, and while loan growth remains sluggish industrywide, smaller banks are adding loans at a faster clip.

Bank of Fayette County is coming off its most profitable year ever in 2011, and Wilson is confident that it will see record earnings again this year. Gregory Mitchell, the president and CEO at First PacTrust Bancorp in Irvine, Calif., has never been more bullish on community banks. "For those community banks that have a strong, scaleable balance sheet, a solid capital base and a capable management team," says Mitchell, "these are probably the best times I've seen in my 20-plus years in banking to gain market share."

Need more convincing? Here are five reasons why now is a good time to be a community banker.

Banks have little to fear from startups, since regulators have essentially stopped approving new charters. Only two new banks opened in 2011, and both were created from the wreckage of failed banks and weren't conventional startups. In contrast, 155 banks opened in 2007.

Given the lack of newcomers, the impact of failures and mergers has been more pronounced. More than 430 banks have collapsed in the last four years, and with roughly 800 on the Federal Deposit Insurance Corp.'s watch list, most experts predict the demise of dozens more before the economy recovers.

Still more banks are expected to evaporate through consolidation. While merger-and-acquisition activity is at a trickle now, some analysts believe a mass consolidation will begin soon and ultimately could slash the number of banks-now at 7,300-by a third in coming years.

"What other industry is consolidating as rapidly as the banking business?" asks Frank Sorrentino 3rd, chairman and CEO at the $730 million-asset North Jersey Community Bank in Englewood Cliffs. "Competition is going away, and that's good news" for the surviving banks.

First PacTrust's Mitchell says many potential sellers are stalling in the hopes of fetching higher prices, but he believes fatigue is setting in. The extended economic malaise and increased regulatory burdens are changing the calculus for sustaining, or restoring, profitability. Expenses will only grow as the Dodd-Frank Act takes full effect. A few recent sellers have cited this as a killing blow.

"The people who have been wishing for that pot of gold at the end of the rainbow are realizing it doesn't exist," Mitchell says. "They are running the math, they are seeing the effects of Dodd-Frank and they are saying, 'No mas.'"

National and regional banks have the advantage of extensive branch networks, but they are downsizing them to cut costs as they contend with new caps on interchange fees, limits on proprietary trading and other direct hits to revenue. Bank of America is closing roughly 10 percent of its branches. Many are in small towns like Ware, Mass., and Augusta, Kan., where community banks already have the dominant market share. Associated Banc-Corp in Green Bay, Wis., is closing about two dozen branches and selling a handful of others to small banks, citing the "changing regulatory and competitive environment."

"Large banks aren't closing branches in places like Bergen County, N.J., where you have 43 banks already tripping over each other. They are closing them in less urban areas where there's less business," says Robert Kafafian of the Kafafian Group in Parisppany, N.J. Those deposits have to go somewhere, and Kafafian predicts it's the community banks in those markets that'll benefit.

The $1 billion-asset First PacTrust grew its loan portfolio by about 15 percent in 2011 without the benefit of acquisitions. A big reason why is its success in landing experienced, well-connected lenders from competitors.

Most of the talent has come from smaller banks that have essentially stopped lending because they are either troubled or too concentrated in one area, like commercial real estate. At those banks, lenders are reduced to managing their portfolios, which isn't going to make them much money since their compensation is driven by production. "Because there are some very good lenders out there who want to lend—who want to provide for their families but can't because their banks don't have the capacity to lend—it's a lot easier to acquire great talent," Mitchell says.

Other community banks have plucked commercial banking talent from larger banks that have been pulling back or further centralizing their decision-making.

North Jersey Community Bank's Sorrentino attributes the torrid loan growth at his bank-total loans rose 27 percent in 2011—in large part to superstar lenders wooed from larger competitors over the past two years.

"In another time, say five years ago, we wouldn't have been able to touch these guys," says Sorrentino.

The $4 billion-asset Berkshire Hills Bancorp in Pittsfield, Mass., has added several teams of commercial lenders (typically three to five people) in recent months, mostly from large banks. The new hires helped the bank grow its commercial and industrial loan portfolio by more than 6 percent between Sept. 30 and Dec. 31. CEO Michael Daly has been telling investors recently that there are so many good teams of lenders available in Berkshire's market area that the bank doesn't have the capacity to take them all on.

There's perhaps even more talent on the mortgage side. That's prompting small thrifts and even business-focused banks to ramp up their residential lending, which can be a significant driver of fee income.

MetLife Bank's exit from the mortgage origination business earlier this year flooded the market with experienced lenders, and thrifts like Provident Bank in Riverside, Calif., and HomeStreet Bank in Seattle scooped them up by the dozens.

Meanwhile, at large banks that remain in the business, many staffers are worried that their employers are distracted by foreclosures, modifications and servicing issues, and dragging their feet on loan approvals. That's prompting some to look for jobs elsewhere.

Cardinal Bancshares in McLean, Va., has hired dozens of mortgage lenders in the past year—mainly from big banks where lenders grew frustrated with the plodding pace of the mortgage process. In 2011, mortgage-related fee income at Cardinal jumped 25 percent.

Few community banks have been as aggressive in raiding rivals for talent as the $3 billion-asset Eagle Bancorp in Bethesda, Md. It has hired roughly 100 commercial and residential bankers in the last 12 months. CEO Ronald Paul estimates that 80 percent of them came from large banks.

The hiring spree has paid off handsomely. Eagle originated $900 million of mortgage loans last year, 10 times what it originated just two years earlier, and its total loan balances rose 23 percent for the year.

It used to be that privately held or thinly traded banks could raise capital fairly easily by teaming up with other small banks to sell pools of trust-preferred securities. But the trust-preferred market dried up during the financial crisis. That's left many small banks with limited options lately.

But capital-raising could get a whole lot easier for small banks soon, thanks to a jobs bill that President Obama signed into law in April. A key provision in the bill would allow banks to have as many as 2,000 shareholders without having to file financial reports with the Securities and Exchange Commission. Since the mid-1960s, that threshold had held at 500, meaning any bank with that many shareholders had to submit to the same reporting requirements as the very largest banks. Wayne Abernathy, executive vice president for financial institutions policy and reguatory affairs at the American Bankers Association, says this had been stifling growth at many community banks for years. Reporting to the SEC can cost a bank tens or even hundreds of thousands of dollars a year, and that's a cost many small institutions simply don't want to take on.

Abernathy says that a number of banks have been "hanging around 400 shareholders"-wanting to raise capital to grow but not wanting to cross the reporting threshold. "It's not just a physical barrier, it's a psychological one," he adds. "Reporting to the SEC means they are inheriting one more regulator."

Under the new law, reporting requirements won't kick in until a privately held bank has 2,000 investors, providing significantly more freedom for banks to solicit locals "who see investing in a bank as a way of investing in the community," Abernathy says. Another plus: more small banks will now be able to offer stock to employees-a potentially powerful incentive in attracting and retaining talent.

Private equity groups are also eager to help capitalize banks, though their criteria are pretty strict, says William Spiegel, a managing director at Pine Brook Partners in New York. Pine Brook is a major investor in the $1.3 billion-asset Green Bank, a C&I lender in Houston, and it is eyeing more investments in similar-sized banks in metropolitan markets.

Spiegel says the "big winners" when the economy hits its stride will be banks with $1 billion to $10 billion of assets that are nimble enough to quickly respond to customers' demands, but substantial enough to make the $5 million to $20 million loans that job-creating businesses will need.

"Private equity investors will help separate the winners from the losers by capitalizing the stronger banks to withstand the current lack of loan demand and prepare for the time when the economy recovers and there is appropriate loan demand," Spiegel says.

Banks like First Virginia, North Jersey Community and the $402 million-asset Meridian all have reported substantial loan growth over the last couple of years, but even Meridian's Annas acknowledges that, in the Delaware Valley at least, most of that growth is coming at the expense of other banks.

"There's very little net new business," Annas says. "We're just swapping each other's accounts."

Meanwhile, there's growing concern that banks that don't necessarily have the expertise in C&I lending are lowering their lending standards to win business. William Demchak, the vice chairman at PNC Financial Services Group, said at an investor conference in March that "smaller banks have become fierce and often irrational competitors for small-business and commercial clients as they struggle to grow top-line revenue in this environment."

First PacTrust's Mitchell was even more blunt. "You've got [bankers] doing really stupid things to secure asset growth; they are dropping their standards from a credit perspective and a pricing perspective and causing future problems for themselves."

Still, many community bankers are confident that loan demand will increase as the economy strengthens.

Annas says he is planning to raise $5 million to $10 million from local investors during the second quarter in anticipation of further loan growth.

Mitchell already is seeing demand surge in southern California. During one six-month stretch last year, First PacTrust reviewed $800 million in commercial loan applications, a clear sign that businesses in his market are ready to borrow. The bank approved about $70 million of those loans.

In the Sarasota area, which was devastated by the real estate crash, "we're seeing a big uptick in residential lending," says Insignia's Brown.

He says property values, while nowhere near their pre-bubble highs, are starting to rebound and confidence is slowly returning to the housing market.

"Residential home sales will lead you into a recession, and they will lead you out of a recession," Brown says.

The one big advantage small banks have always held over large banks is that they are more familiar with their customers and generally are more willing to tailor products and services to best meet customers' needs.

Bankers and investors say this advantage has strengthened as large banks have become even more rigid in their underwriting and decision-making, and as they've alienated customers with new fees.

Mitchell says many consumers and small-business owners historically stuck with larger banks because the big outfits have convenient branch networks, lots of automated teller machines and sophisticated online banking capabilities, and weren't charging much for those services.

Now that most large banks are eliminating free checking, and small banks can offer similar conveniences through remote-deposit capture and surcharge-free ATM networks, "the differences aren't as great as they once were," Mitchell says.

Customers seem to have noticed. New data from J.D. Power and Associates shows that more than 10 percent of customers at large and midsize banks moved their accounts to smaller banks and credit unions in 2011.

Data from the Birmingham, Ala., consulting firm Bancography suggests that consumers began fleeing large banks even before they began jacking up fees last year. Excluding large corporate and municipal deposits, which skew results in large banks' favor, community banks with less than $1 billion of deposits saw deposit growth of nearly 19 percent over the last four years, compared to 3.5 percent at large national banks and 5.2 percent at super-regional banks, defined as those with branches in 10 or more states.

Small banks also have the advantage of being more nimble.

Insignia's Brown says he recently approved a loan to a borrower who was turned down by a large bank even though he had $5 million in the bank and was making about $150,000 as a consultant. The reason he was rejected by the large bank: he's semi-retired and couldn't show steady income.

"A loan like that comes to me, and it's pretty easy to approve," Brown says.

Pine Brook's Spiegel says that business owners, too, want this kind of flexibility from their bankers.

"Big, out-of-state banks tend to be very clinical. They say, 'Here's my underwriting box, and any request for deviation has to go all the way to headquarters,' and headquarters doesn't know the client and therefore may not respond in a client-friendly way."

There are signs that small banks are, in fact, winning the competition for C&I loans. According to FDIC data, C&I lending in the four years ended Dec. 31 rose 0.6 percent at banks with $100 million to $1 billion of assets and by roughly the same amount at banks with $1 billion to $10 billion of assets. At banks with $10 billion of assets or more, total C&I loans fell 7 percent in that same time frame.

Service, though, is increasingly about having the latest technology. Business customers especially want mobile banking, remote deposit and cash-management services, and small banks without these basics will risk losing customers, says North Jersey's Sorrentino.

"I've never looked at technology as an expense; to me it's always an investment," he says. "You never want to be in a position for a customer to say he can't bank with you because you don't have the firepower."

Still, when it comes to service, it's human contact that matters most, says Bank of Fayette County's Wilson. He says his bank has the No. 1 market share in the county because it does the right thing by its customers. He's proud of that, even if it means being less profitable than some competitors.

"Who needs a 20 percent ROE?" he asks. "Community banks were never meant to be huge moneymakers for shareholders. We're here to make a difference in people's lives."

Alan Kline is an editor at American Banker.

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