Has Consolidation Killed the Community Bank?

An argument that I hear occasionally is that consolidation of the U.S. banking industry has put community banks on a path towards extinction. Two economists at the Federal Deposit Insurance Corp. (FDIC) have shot down this theory in a new research study whose findings are counterintuitive.

On the face of it, the industry’s consolidation over the past 30-plus years has been pretty dramatic. The FDIC says there were approximately 20,000 U.S. banks and thrifts in 1980, and this number had dropped to 6,812 by the end of 2013. A variety of factors have been at work. The biggest contributor, according to the study, was the voluntary closure of bank charters brought by deregulation, including the advent of interstate banking. A lot of the “shrinkage” that occurred between the mid-1980s and mid-1990s wasn’t so much the disappearance of whole banks as it was the rationalization of multiple charters by the same corporate owner to save money.

A couple of recessions—from 1990-1991, and again from 2007-2009—also played a role in the industry’s downsizing. The FDIC says that bank failures accounted for about 20 percent of all charter attrition between 1985 and 2013—a culling of the herd which is painful but ultimately healthy since it tends to eliminate the weaker management teams.

Interestingly, the study did not look at how many bank charters were eliminated through acquisition, although I think we can safely assume that this has played an important role, particularly among the larger banks. In 1990 the 10 largest U.S. banks controlled 19 percent of the industry’s assets; by the end of 2013 their share had climbed to 56 percent. That increase in financial concentration is almost all the result of acquisitions of large banks by even larger banks, much of which occurred in the 1990s.

While the big banks just got bigger, the really small banks mostly disappeared. In what I thought was the study’s most interesting finding, the number of banks with less than $100 million in assets dropped by a stunning 85 percent from 1985 to 2013. For banks under $25 million, the decline was 96 percent. Again, the FDIC doesn’t say why, although I think we can assume that acquisitions, charter rationalizations and failures all played a role.

A central point of the study is that there are still plenty of community banks around, especially if you define them not by an arbitrary asset size, but rather by what they do and how they do it. Community banks, according to the FDIC, “tend to focus on providing essential banking services in their local communities. They obtain most of their core deposits locally and make many of their loans to local businesses.” Most banks in the U.S. would meet this definition of “community,” including a great many that are well over $1 billion in assets.

How might consolidation affect community banks going forward? The FDIC study ends with the upbeat assessment that community banks will continue to be an important source of funding to local businesses, and I would agree in part because I am uncertain about how much more consolidation is likely to occur.

I pointed out in a February 4 blog that there were 225 healthy bank acquisitions in 2012 and 224 in 2013, according to SNL Financial. And I offered a prediction that there would be between 225 and 250 acquisitions this year and perhaps as many as 275 in 2015. That still sounds about right, and it would put the pace of consolidation back to where it was in 2007—or a year before the financial crisis. Many of those deals will likely involve community banks, and while that would lead to a decline in their overall population, it would also create “local” institutions that are larger in size. It certainly won’t decimate the ranks of community banks.

I don’t believe that community banks are facing extinction, but they are facing some very significant challenges in the years ahead—and not from consolidation. The sharply increased cost of regulatory compliance might lead some community banks—say, those under $100 million in assets —to sell out if they can find a buyer; others will respond by trying to get bigger through acquisitions so they can spread the costs over a wider base.

Gaining access to capital will also prove to be a huge challenge for many smaller banks. By “smaller” I am thinking of institutions with $1 billion in assets or less, although the cutoff point might be higher. The higher capital requirement that has been established under the Basel III agreement is a permanent minimum expectation. Traditionally, banks have had the freedom to manage their capital to fit the environment they found themselves in, preserving it when times were bad and leveraging it when times were good and they wanted to grow. Now, banks that want to grow might need to raise additional capital to support a larger balance sheet. But as the banking industry’s capital level has grown, its return on equity has declined (a function of simple math) and not all investors will be interested in a small bank offering limited returns. I believe there will be a great deal of competition between banking companies to attract capital, and there will be winners and losers.

A third challenge is the dependency that many community banks have on commercial real estate lending, a historically volatile asset class that resulted in hundreds of bank failures in the early 1990s, and again during the most recent financial crisis. The most enduring community banks could be those that are able to diversify into other loan categories so they are not at risk when the next commercial real estate crash occurs. But diversification will require the acquisition of talent and skill sets that most community banks do not possess, so it’s a strategy that must be pursued with purpose.

The challenges facing community banks today are real, but consolidation isn’t one of them.

This article originally appeared on The Bank Spot and was reprinted with permission.