Dealing With The Compressing Margin

Dealing with the compressing margin: the community banking perspective

Community banks have been hit harder than many with margin compression in the past 18 months. Many true commercial lenders have primarily variable, prime-rate based loans, which continue to reprice downward each time the Fed lowers rate. At the same time, once deposit rates reach a certain floor, there is nowhere else to go with lowering the rates. Loan yield continue to decline, which deposit rate remain extremely low, but without going any lower. The result: shrinking margins.

This is a particularly acute problem for community banks for several reasons:

1. They are typically more dependant on margins than larger banks because their fee income sources are more limited. They do not have sufficient scale for meaningful investment income, and lag on many other fee-income based products due to scale issues or lack of market demand. 2. Those community banks that did seek fee income aggressively, often got there by improving the penetration of debit cards among their customer bases, a natural companion product to the checking account. The recent Wal-mart settlement significantly curtailed such fee income, thereby impacting many of the community banks, although not quite as seriously as major debit card issuers. 3. Community banks typically rely on core funding sources, which, given the rate environment, are relatively more expensive than FLHB borrowings and other institutional markets to which they have limited access. 4. Communtiy banks often do not have derivatives and complex investment strategies. They may not have been able to buy products to shelter their margin or make investments in bonds that cushion the declining loan yields on the way down. For these and other reasons, community banks are struggling to maintain profitability. Many are resorting to the typical solution: cutting expenses. While this is an excellent opportunity to get rid of unproductive overhead, it is also a time when the temptation to slim down presents its own risks. Sometimes, in the zeal to cut expenses and make quarterly estimates, banks cut to the bone, impairing their ability to generate future revenues and mortgaging their future for the sake of short- term earnings. This is one pitfall community banks will be well served to avoid, especially as others succumb to such temptation. Cost cuts that are too deep hurt service levels and other aspects of the competitive advantage many community banks boast, so they should be careful to cut with reason and care. Community Banks are often not heavily traded. While stock price matters to every public company, they can enjoy less pressure on earnings from the street than others. Now is the time to be more thoughtful than ever on strategic investment and building future income streams, while weathering the current crunch. It is also a good time to recapture market share through competitive service levels and not through Kamikaze pricing. A community bank can garner share by giving customers value, which is more than price alone, especially in today’s environment. This is also a good time to examine underutilized fee income opportunities, including partnering with other vendors and possibly even larger banks to offer customers a fuller product line that will provide better balance between margin and fee income. Anything from outsourcing investment management and Trust services to merchant card and treasury services, products that are offered by most larger banks, can be considered and offered, depending upon local market needs. Another possible income source is leveraging the community bank’s loan originating capacity. For example, originating 7(a) and 504 loans economically can be turned into a fee income opportunity if sold in a batch mode or on a flow basis to the many buyers in the marketplace. If the bank is reluctant to keep the risk on the balance sheet, it can still say “yes” to its customers and then place the risk (i.e. loan) with another bank who enjoys a more diversified portfolio. In sum, today’s environment is tough on community banks. But, like any other challenge, it also offers opportunities that will benefit those who are willing to capture them.