In a recent interview at the American Banker, Fred Price of Sandler O'Neill and Partners commented that small community banks are going to have the hardest time surviving. The reason, said Fred, is the anticipated shrinking margins.
Net interest income represents core earnings for community banks, much more so than for larger institutions. Fred perceived that small banks have fewer available strategies to offset that slide.
Mr. Price and I agree on one thing: Community banks are going to have a tough time surviving in a shrinking-margin environment.
Indeed, they currently do not have as much fee income available to them to compensate for a reduction in core earnings associated with margin shrinkage.
However, given technological developments, the advent of buying consortiums, and the availability of fee-income-producing services "for rent," I believe that small community banks can make their size transparent by accessing others' economies of scale to compensate for a reduction in core earnings and expand their sources of fee income or reduce the cost of operations.
Either way, it is not only interest rate risk management that would be at the core of community bank survival in the future, as Mr. Price posited.
The difference between the past banking environment and today's community banking scene is that community banks have the option of joining together with other vendors or other community banks to improve their fee income and efficiency performance in ways that were not available to them in the past.
Let's take fee income, for example. A small community bank can now offer trust services, mutual funds, annuities, insurance, cash management, financial planning, and even international finance by linking with the providers of those services.
Technology has enabled small banks to access other peoples' "production facilities" without needing to build an infrastructure to produce such services themselves.
While community banks have performed poorly relative to the rest of the industry in generating fee income as a percent of total income, that historical trend does not have to persist.
Community banks can continue to do what they do best, which is to serve customers, sell services, and build relationships. They do not need to "produce" all the services that those customers require.
Instead, they can leverage their distribution and their relationship management capabilities by selling fee-income-generating products through their branches, tellers, and platform personnel. Thereby they can improve fee income performance without significantly increasing cost.
Conceptually, this is one of the major strategies for community banks' future survival and maintained profitability.
Similarly, community banks can access other financial institutions' economies of scale in order to improve cost performance.
Companies with assets of $200 million and under can significantly improve their performance by tightly managing expenses, paying attention to the basics, and out-sourcing economically feasible services. These go well beyond data processing and into internal audit, telemarketing, certain sales activities, asset liability management, and portfolio management.
By efficiently managing the cost structure, the small community bank does not sacrifice the quality of service it offers its customers, nor does it compromise the integrity of relationships. In fact, just the opposite.
Outsourcing is a concept that permits small banks to focus on what they do best, which is nurturing the franchise and the customer relationship in line with customer preferences.
Although there is a national trend toward alternative distribution networks that must not be neglected by any depository institution, the majority of consumers still prefer the physical presence of a branch and being served by a local provider, as evidenced by the American Banker's consumer survey year after year.
Community banks have the advantage of offering services efficiently in the way the customer appreciates most. This is particularly true for customers in non-metropolitan areas or in highly cohesive communities and neighborhoods within metropolitan areas where community banks excel.
For example, the Polish and Ukrainian communities in Chicago appreciate being served by tellers and platform personnel that speak their language.
They prefer to visit the branch of the $200 million-asset institution that serves them directly, rather than be reached by telemarketers who do not speak their language.
Notwithstanding the increasing propensity to conduct banking services swiftly and efficiently through alternative distribution channels, most community banks can still capitalize on their customer relationships without incurring additional costs by focusing on what they do best, which is product distribution and relationship enhancement, and by outsourcing the production aspect of the business, which can be merely a distraction to tending to their core business.
By adopting this conceptual approach, community banks will be able to compete effectively in the future since they will improve their fee income performance and decrease their costs by piggybacking on others' economies of scale.