The Crisis in Community Banking

Lost in all the Sturm und Drang surrounding the financial crisis of 2008 – when several large U.S. financial institutions either failed (Washington Mutual Inc.), sold themselves off to avoid failure (Wachovia Corp.), or were simply propped by the federal government (Citigroup) – is the very real crisis facing community banks throughout the country.

The nation’s largest banks – all of which received direct capital infusions from the U.S. government under the controversial Troubled Asset Relief Program (TARP) – are once again profitable, and many of them have long since paid back the money. On the other hand, a great many community banks are still struggling to regain their footing – and for them the long nightmare is not yet over. 

Haves vs. Have-Nots
 
The disparity in fortunes between the industry’s largest institutions and smaller regional banks is framed perfectly by two bank stock indexes published by Keefe Bruyette & Woods Inc. The KBW Bank Index (BKX), which is comprised of 24 U.S. money centers or super-regional banks, was up 17% on the year through late October, while the KBW Regional Banking Index (KRX) – which is comprised of 50 smaller regional banks – was up just 3% on the year. Clearly institutional investors like what they see in the BKX universe, and that has allowed large banks to raise capital at a reasonable cost and put their troubled past behind them. 
 
Smaller regionals have had a more torturous recovery – and many of them were actually quite grateful to receive their TARP funds because when that money was being doled out two years ago it was the only available source of capital for most banks. 
 

Overdosing on Real Estate

But most challenged by far are the thousands of small community institutions that are either privately owned or have thinly traded and highly illiquid stocks and haven’t been able to raise fresh capital to fuel their recovery. For the most part, their downfall has been the result of bad commercial real estate and real estate development loans, including loans tied to the grossly overbuilt housing market in such places as Florida, Nevada and Arizona. 
 
Although the U.S. housing bubble attracted lenders, investors and buyers like moths to a flame, there is a reason why so many community banks ended up being so overexposed to real estate. After 30-some years of disintermediation and conglomerization, there are only a limited number of ways that community banks can make money. Several large asset classes, including car loans, credit cards, mortgages and home equity loans, are now dominated by giant financial companies that have enormous marketing and efficiency advantages. 

Expanding Their Business Model

Many community banks focus on small and medium-sized businesses because it’s one market where their superior service gives them a competitive advantage over the big banks, but generally they lack the revenue diversification of their larger peers. So when the residential real estate market took off in the early 2000’s and local developers were looking for loans to finance their construction activities, many smaller banks saw that opportunity as manna sent down from heaven. 
 
As the U.S. economy improves and the real estate market gradually recovers, community banks will rebound as well. Unfortunately, their underlying weakness – the lack of revenue diversification – will remain. And the challenge for community bank CEOs and their directors will be to expand their business models to include a variety of fee-based activities that will make them less reliant on cyclical lending markets like real estate.
 
Otherwise, the community-banking sector will just be an accident waiting for the next recession to happen.