What Community Bank Investors Worry About

What do Community Bank Investors Worry About?
By Anat Bird, CEO, SCB Forums, Ltd., and Felice Gelman, Managing Director, Sunova Capital

Mid-cap banks have their challenges in attracting and retaining institutional investors. While larger pension funds and other mega-institutional investors are limited to investing in the top 25 banks, many other investors find mid-cap banks to be attractive investment candidates. They are often misunderstood and under-communicated, and, as a result, under-valued.

As mid- and small-cap banks seek to attract new institutional investors, they might find it interesting to note where investors' worries were over the past twenty years. It may also be enlightening to investors themselves to review how well on (or off) the mark they have been in the past.

1. Early 1980's: deregulation will destroy banks' cost of funds. As Reg Q was lifted, investors anticipated that banks, which had mostly free funds until that point, will now be compelled to pay interested on the bulk of their funding, thereby destroying their funding base and cost profile. Those worries did not materialize. In fact, banks found ways to expand their funding bases using interested as a product differentiator and attracting a broader range of depositors. Money market accounts became an important core funding source and an effective competitor to brokers accounts. Lifting Reg Q proved to be a bonanza for depository institutions, not a bust.

   It should be noted that many thrifts which did not manage their asset/liability risk effectively during this period did indeed suffer, sometime critical losses. The underlying cause for these losses, however, was not the new deposit opportunities but their practice of funding short and lending long.

2. Mid-late 1980s: Wall Street will disintermediate assets from the banks. When Wall St. moved into small and middle market lending, investors feared that banks will lose their most important asset generation source. In fact, SuperCommunity banks were created to take the challenge face-on, and those banks enjoyed wider spreads than most banks in the system. Prior to the move by Wall Street, most banks aspired to be money-center banks, or behaved like mini money-centers. Companies like Mercantile of St. Louis, $1.5 billion at the time, had no business owning 10% of their assets in Latin America.

   The changing competitive landscape forced those banks to find a different strategic position or market niche. Norwest, for example, chose to rebuild itself by focusing on America's hinterland and the basics of banking. It showed that it's possible to grow while focusing on local markets and using the model of 'outlocal the nationals, outnational the locals.' Community banks benefited from Wall Street's entry into the asset side by becoming more focused and creative.

3. Early 1990s - Mergers & Acquisitions will eliminate the smaller players. Investors were anticipating (and encouraging) the sale of most smaller banks into larger aggregators, resulting in a highly dense industry. Industry gurus predicted in 1993 that there will be 100 banks in the US by 2000. The expectation was that M&A will virtually eliminate the community bank position.

   The wave started in 1984, when Interstate Banking restrictions wer lifted and Sun Banks of Florida merged with Trust Company of Georgia. The next decade saw the industry shrinking from 13,000 banks to 7,500, but the community banks were not eliminated. Instead, community banks again rose to the occasion by demonstrating that they can grow even when consolidation occurs and especially when bigger players are licking their wounds. They showed that they can produce good earnings and asset quality by effectively competing against the mega-banks.

   The M&A wave further produced opportunities for de novo banks. As consolidation continued, new bank creation intensified. For example, in 1997, Huntington bought First Michigan Bank in Grand Rapids, MI, which is a great bank market. Huntington paid 3 times book for FBM; the banks has now grown back into 50% of its asset size when bought. Five de novos were established in the market in the past five years. The biggest is not $1 billion and has experienced 40% CAGR since inception in 1998. The second largest bank is now $750 million, and two of the other three are thriving as well.

   Community banks defied investor concerns by demonstrating that their model, if effectively executed, works particularly well in highly consolidated markets. They also showed that mega-bank mergers produce enormous opportunities for relationship-oriented institutions, and that's when the term 'the gift that keeps on giving' was coined.

4. Late 1990s: customer profitability and CRM will destroy community banks' value proposition and create a competitive advantage for the larger banks.

   Customer profitability changed the way larger banks were doing business. Once they realized that the top 15-20% of their customers contribute 120% of the profit, many embarked upon programs designed to divest themselves of the 'losers.' Very few believed that every customer has the potential to become profitable. Instead, they instituted fees and other programs designed to drive customers away from the bank.

   Many community banks found that the larger banks' sow's ears were their own silk purses. At the same time, the jury is still out on whether small banks indeed do better with customers who were pushed out by the larger banks. Most community banks cannot explain how they converted these lemons into lemonade and where the profitability came from. At the same time, customer acquisition, margin expansion and profitability growth proved to be achievable in community banks in the late 1990s and today. While the analytics may not be there to explain how this was done, the results are encouraging.

   We believe that community banks did a better job employing relationship-based selling to convert customers into profitability than the money center banks. By selling profitable services into unprofitable customers as well as reducing operating costs, they found ways to turn marginal customers into profitable ones.

5. 2000s: Smaller companies will not be able to survive the technology pressures. Investors anticipated that pre- and post Y2K will prove daunting to community banks in terms of technology spending and adaptation. They felt technology issues will stymie their growth and motivate many to sell. Investors were right in some cases; some community banks felt they could not cope with the Y2K event and sold their banks. Many others discovered that the larger banks spend billions of dollars on technology for little tangible returns, while they benefit from service bureau scale economics and technological innovation. Further, many larger banks got tangled up in their legacy systems, while smaller banks remain more flexible and can access less expensive technological solutions both for day-to-day operations and during acquisitions.

   Investors concerns for community banks by and large were not fulfilled in the past twenty years. Instead, the industry sector adapted to changing regulatory, technological and competitive pressures by producing creative and effective responses. This is a vibrant and successful segment of our industry, and we predict it will continue to be that for many years to come.