Two recent American Banker articles reached opposite conclusions on the future of community banking. Unfortunately, they both address the wrong question. The issue is not the future of community banking. Rather, it is the future of community banks.

Low returns on equity (ROE) and depressed stock prices threaten the viability of community banks. Historically, community banks operated as modest-sized, relationship-based institutions using local retail deposits to make loans in their communities. Increasingly, community banks are defined based on their business model, not size.

Prior to the crisis, many banks shifted to a transaction-based real estate lending business model to achieve faster growth. That model no longer works in the current economic environment. This is evidenced by the failure of many community banks to earn their cost of capital. Investors want aggressive plans to boost ROE to improve their investment values.

Community bank performance problems reflect both cyclical and structural elements. Tepid growth depresses loan volumes and loan-to-deposit ratios. Equally important is the Federal Reserve's low-rate policy. This has curtailed yield curve arbitrage and eroded the value of core deposits and the branch network. Moreover, the Federal Reserve has signaled it intends to continue its low-rate policy until at least 2014. Waiting for a cyclical recovery of these factors is unlikely to please investors.

As proposed, Basel III poses a significant new and less understood structural challenge to community banks. It impacts risk weights and capital requirements for banks with assets at or above $500 million. Although subject to changes and phased in over time, it negatively impacts many pre-crisis business models. Consequently, banks need to re-engineer their strategies and asset combinations to prove they make sense as standalone entities.

Going forward, community banks should exploit their advantages based on convenience, personal service, local decision making and a relationship model based on deep customer knowledge. There are four characteristics banks need to make this transition.

First, there will be fewer, but larger community banks. It is difficult for banks below $1 billion in assets to produce adequate long-term risk-adjusted ROE due to higher operating costs. The almost 6,000 banks with assets less than $500 million will shrink by at least one-third over time. In any event, the objective should be profitability and not the number of community banks. There are simply too many banks to save.

The next factor is stability. Banks must demonstrate the ability to manage through the cycle. This means specifying and adhering to a consistent risk appetite supported by adequate capital. Additionally, risk management must be strengthened – especially the ability to manage loan concentrations. Assets should be originated with an eye towards diversification to help break the real estate lending addiction.  

The third factor is efficiency. Successful community banks must achieve efficiency ratios in the mid-50% range to generate acceptable returns in a slow growth higher capital environment. They are unlikely to reach this level through traditional incremental cost cuts. Instead, difficult strategic decisions must be made. This includes increased focus on eliminating peripheral business lines and marginal customers. Also, noncore back office services can be outsourced. Finally, rethink your value proposition to lower delivery costs. For example, move from a high-cost branch delivery model to lower-cost mobile banking. This supports the right sizing of branches consistent with the coming generational shift away from branches by younger customers. An estimated 10-15% of branches could be eliminated with those remaining reserved for complex transactions.

Enhanced capital management is the final factor. This requires adapting an asset-lite approach, minimizing high-risk weighted assets such as risky mortgages and construction loans. This entails adjusting business mix and asset combinations through acquisitions, divestitures and organic shifts. Otherwise, institutions will experience unwelcome RWA increases of 15% or more. Capital should be withheld from low return business units regardless of the revenue impact based on risk-adjusted capital allocation. Banks may be generating more capital than can be profitably employed because of these actions. The excess capital above target levels can be returned to shareholders consistent with regulatory guidelines through dividends and share repurchases.

Institutions adjusting to the new market environment can generate asset returns exceeding 1% with ROEs in the 12% range sufficient to cover their cost of capital. This can improve price to tangible book pricing multiples to at least 150% even with minimal growth. These banks will increase in value and retain the ability to attract capital to exploit market opportunities as conditions improve. The future of community banking is both different and bright. Only those community banks flexible enough to adapt, however, will be part of it.   

Joseph V. Rizzi is senior investment strategist for CapGen Financial, a private equity firm focused on financial institutions.