American Banker recently gathered four panelists — Fred Cannon at KBW Inc., Scott Siefers at Sandler O'Neill & Partners LP, Joe Stilwell at Stilwell Group and Brad Whitman at Barclays Capital — to discuss the year ahead for community banks. This is an excerpt of the wide-ranging discussion.

How are community banks positioned headed into 2012?

SCOTT SIEFERS: I'm afraid it's not getting any easier. On the plus side there's the systemic recapitalization we've seen over the last couple of years, and credit trends continue to improve. Having said that, the smaller you go in the banking space, the more spread-dependent you are and the less diversified your revenue stream is. The smaller banks also tend to have more real estate exposure. Given the flat shape of the yield curve, the fact that the economy isn't progressing nearly as strongly as we would hope, it's going to be a tough environment over the next year at least.

FRED CANNON: For community banks, it's certainly a tough operating environment. The Fed promising to be on hold through 2013 means there's little aspect for relief in interest margins and rates. The credit recovery we've seen is starting to wane … so really it's all about profitability at this point, and that's a tough picture.

Are small banks better off growing or shrinking loans?

JOE STILWELL: As an investor, what you want to make sure happens is that growth doesn't take place for the sake of growth. You're looking for intelligent growth. It's hard right now. I think the Fed's zero interest rate policy is causing a lot of the more creditworthy small businesses to just pay down loans. One of the best things we're seeing is controlled shrinkage, where [banks] are paying off higher-cost liabilities, particularly with some of the borrowings and moving back towards more of a core business.

SIEFERS: One of the big misconceptions about this recovery is that banks are very hesitant to lend. I think in many cases they're quite willing, but there's just not a lot of creditworthy borrowers. On the supply side, it's very difficult to commit capital when you don't know what the rules are going to be. So there are frustrations on the supply and the demand side.

BRAD WHITMAN: As securities are running off and you're trying to replace it with more attractive securities, they're just not out there. How do you find attractive loans? C&I seems to be one place people look. Fee income is another place. But getting that most favorable match for any given institution is tough. It's very hard to see when this is going to free up. Net interest margin compression … looks like it will be the story for the next couple of quarters.

When will deposits start to benefit banks again?

STILWELL: You can still find an awful lot of institutions that have higher-cost borrowings on the balance sheet, which they probably have no business having in the first place, but they were just playing bond market with the securities portfolio. To the extent they're taking deposits in, the sticky deposits will always have a value.

SIEFERS: I'm not aware of any community banks … looking to turn away deposits. It's certainly a real problem for net interest income growth, just to have this excess liquidity with nowhere to go. It is tempting to reach out over your skis from a risk standpoint, given that you are so awash in liquidity. The value will be realized either in a sale or in a more accommodating rate environment. Unfortunately, we might have to wait a while for that rate environment to reveal itself.

Where should small banks look to find fee income?

SIEFERS: I would say asset and wealth management. I don't necessarily want to see them getting into the more esoteric businesses, such as getting really heavy in the capital markets or investment banking. Wealth and asset management are pretty easy ones. You already have relationships on the small-business side. To the extent that you can develop at least some capability there, that's always struck me as the most logical one. It's really tough to make a critical error with smaller bolt-on businesses. There are risks to it, but they tend to be contained.

WHITMAN: It's definitely logical. A lot of our client base is talking about it and asking us about how they get into that business. High-margin business, low capital requirements, they make sense. Do you build them organically or through small M&A trades? You can do it organically, but it does take some time to build that expertise.

As we've been saying in all aspects of the business these days, pricing becomes difficult [to buy into a business]. It sounds good. The execution, I think, is pretty tough in this environment.

We've seen more branch and bulk loan sales at good prices. What does this say about M&A?

WHITMAN: That is a positive development. Nonperforming assets and loans have moved to better prices. A couple of things have changed. One, community banks have a lot of capital, so they're willing to offset that and clean up the balance sheet. They're getting some pressure from regulators in terms of what numbers they need to meet. A little more push, a little more capital, a little better pricing means that we are seeing people being more aggressive about moving nonperforming loans.

The core deposit premiums have been pretty good. We got into a funny place with the FDIC deals having negative premiums in low single digits, but now we're really getting to real numbers. The pricing gives a little more motivation for someone to say, "You know what? Let me clean house a little bit. Let me rationalize and let me move these at a decent price."

We've had 92 banks fail this year. What about 2012?

WHITMAN: I think we all anticipate there would be a lot less FDIC activity from a receivership point of view as we move forward.

CANNON: If I look back two years ago, I was a lot more excited about FDIC deals at that point. The really frustratingly slow pace of resolution has been a real problem. The policy seems to be that a troubled institution can skate by with no or negative capital until there is a liquidity problem or until the FDIC gets around to shuttering them. That's really destroyed a lot of the attractiveness in investors' minds.

What are the views on capital management?

STILWELL: For the stable banks that are already at the 9% to 10% capital level, they're going to be throwing capital off. You're looking for the best managers to use the capital to acquire others, and you're looking for the bad managers to make sure that they're not doing anything else and they're returning it to the shareholders if they're generating capital from a good franchise.

CANNON: In general, you want the banks to be holding 9% to 10% [capital] at this point in time. While we think ultimately maybe some of the banks may be able to operate a little bit lower, why take that bet now? I think that those ones above that, we are seeing a couple of things. If you're trading below book value and you believe your book value is accurate, that's a signal that buybacks make a lot of sense. One of the interesting developments on capital redeployment has been the variable dividends that we've started to see, which we think is kind of a creative way to approach the issue for an ongoing relationship with your shareholders.

SIEFERS: If there is one area where smaller banks really do have an advantage, it's on the capital management front. I haven't necessarily noticed some of the more creative capital management strategies really turbocharging stock prices, but they do provide defensive mechanisms, unique characteristics that allow for some sort of story for the stock. So I like them when and where appropriate.

What are the biggest challenges for community banks in the next 12 to 18 months?

SIEFERS: I would say the lack of scale. The smaller you are, the more difficult it is incrementally to absorb costs. So I don't know what the perfect number is where you have scale, but that strikes me as the biggest hindrance.

STILWELL: The biggest risk has to be another recession. That having been said, the underwriting standards are worlds better than where they were a number of years ago.

CANNON: I think the rate environment, at least for the next 18 months, is just going to be tough on the banks. The value of the thing that you bring to the table the best, the deposits, just isn't there. Managing through that is the biggest challenge because we think the community bank system is well poised for even a mild recession at this point, given the underwriting that we've seen in the last couple of years.

WHITMAN: Banks are just running out of some levers they can pull. So expense reduction, they really try to do the best they can there. Costs of deposits, how low can you go with rates? Aside from some of these macro things, I think that finding profitability is the biggest issue for any institution. I think that's going to be the difference between those guys who are doing well and those who aren't. It is a competition, right? Whoever can win that competition is going to be well placed.

What will we be talking about a year from now?

CANNON: I think there's a potential for an acceleration of M&A going into next year. We're starting to know these asset values. I think the asset sales are good news for M&A. I think that's held a lot of folks back. I think there's a little bit of frustration by management in terms of getting your costs out. At some point, the only way to really get costs out is through M&A. We think we'll probably be talking about that a lot more next year.

SIEFERS: I'm hopeful for more of a rationalization of expectations. For the past couple of years, we've had this notion of normalized earnings, but what's been happening over the last couple of quarters is that certainly investors and more and more management teams are realizing this is that normal environment.

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