Many community banks are positioning themselves as safe havens at a time of economic turmoil, and the smallest among them — the roughly 3,000 institutions with $100 million of assets or less — appear to be safest of all. At Dec. 31, these banks had, on average, higher capital levels, fewer charge-offs and stronger net interest margins than banks in all other asset classes, according to Federal Deposit Insurance Corp. data.

Yet their relative strength is not translating into deposit growth. While total deposits increased at banks in all other asset classes between Sept. 30 and Dec. 31, they declined 2.1 percent at banks below $100 million, continuing a troubling trend for this group.

Community banks have been steadily losing market to larger competitors for two decades now. But it may come as a surprise that even during the meltdown year of 2008, the industry saw new milestone divides between small-and-big retail banking operations that, according to a recent report from Celent, now clearly indicate that there's no "end-state" for banks below a critical mass of assets: it's grow or die. "In the retail deposit business, customers value networks of branches and ATMs," says Celent senior banking analyst Bart Narter. "The product is relatively simple so it's a scale business."

It's not just the $100 million-asset banks losing market share. Deposits at banks between $100 million-$300 million-in assets are shrinking at an average annual compound growth rate of 19 percent, says Narter, who in February released a report titled, "It Takes More Than a Village: The Decline of the Community Bank."

One of the more troubled vital signs is efficiency ratio. Between September 2007 to September 2008, the gap in average efficiency ratios between banks with less than $100 million of assets (rising to approximately 80%) and the 115 banks with $10 billion of assets or more (about 60%) widened by six percentage points. That disparity, Narter says, "is huge, and that's what caught my attention."

The turmoil engulfing some of the nation's largest institutions, particularly Citigroup and Bank of America, doesn't alter his outlook for the vast majority of the $10 billion-plus banks that will use their scale and acquisitions to boost deposits and footprints. Narter doesn't believe, certainly, that all small banks that can't break the $300 million-asset barrier are destined for extinction or the auction block. Those in smaller communities that do not have a lot of competition tend to do well, as do those with special niches, such as private banking. According to Capital Financial Group in Washington, D.C., 145 banks between $100 million and $300 million not only have efficiency ratios of between 50 percent and 60 percent, but also have average double-digit returns on equity. Capital Financial managing partner Mary Beth Sullivan says she thinks it takes more than revenue measures to judge small vs. big performance. "For one thing, credit risk isn't factored into an efficiency ratio," she says.

John Carusone, president and chief executive of the Bank Analysis Center in Hartford, Conn., believes that instead of efficiency gaps, small banks have been harmed more by the strains on net interest margins that have narrowed by more than 100 basis points in 20 years. And that doesn't put them on life support. "It makes it more complicated and more challenging...but the community banker has always competed on basis of personalized service flexibility, local decision making, and creativity.

"And I don't see many discussions about the nationalization of community banks," he adds.

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