09/03/2013 03:47 pm ET | Updated Nov 03, 2013

The Future of Regional and Community Banking

When I think about the future of community banks, my mind goes back to the Panic of 2008 and The Great Recession that followed. For those who watched the scary headlines from those days, the names that drove the crisis were players like Wachovia, Washington Mutual, Lehman Brothers, and Countrywide Financial, not your local community bank. We went through a massive bailout program and TARP gave these financial institutions a change to breathe, reorganize, and repair their balance sheets.

Some warn that the current financial environment creates a world where roughly 75% of the of the nation's financial complexion falls under the branding of nine banks, including Bank of America, Citi, Goldman Sachs, Wells Fargo, JP Morgan Chase, and others. Some feel that these banks have far too much power and should be broken up into smaller companies; they feel that "too big to fail" fostered an atmosphere of malfeasance during the run up to the collapse and beyond.

However, I am more fascinated about the 6,000 other banking institutions that cover the other quarter of our national banking complexion. Some are larger regional banks that might be powerful players in a multi-state or in metropolitan areas. Most of them tend to be small-to-mid-sized regional banks or smaller community banks.

Last week, I read an article The Huffington Post by Professor Tanya Marsh who teaches law at Wake Forest. She dismissed the role that regional and community banks play within our national fabric. She spoke at length about the decline in the number of smaller community and regional banks. Her comment suggesting a causal relationship between the rise of pawn shops and the decrease of community banks comes across as sophomoric and a bit silly.

However, a number of comments were factually wrong and bear correcting. Her notion that "Community banks traditionally serve non-standard customers who lack the deep credit history or documentation necessary for the model-based transactional lending used by large financial institutions" is equal parts incorrect and insulting.

Here is the truth. Community and smaller-to-mid-sized regional banks serve a variety of interests. They tend to favor the needs of local and mid-sized businesses or specific socio-economic communities who want a more personalized approach to banking. They serve an important and often very profitable niche often overlooked by the one-size-fits-all approach offered by the large megabanks. A couple of years ago, I made a presentation in front of a Northern California community bank during the worst of the Great Recession and this audience had an unshakable loyalty to the family which started the bank. Nobody had any plans of leaving.

Why? Leaders of local and mid-tier banks tend to live in the communities they serve. Deposits generated locally are often funneled back into community-based loans. It is far easier to reach out and connect with the President of a community bank than the CEO of Bank of America. Organizationally, regional and community banks are far more nimble than their megabank peers. Finally, community bank leaders tend to be more involved with the philanthropic affairs of their local communities than megabanks who take a more national approach. Sure, there may be some loan approvals that add character into the mix, but well-run community banks are very profitable. When added together, community banks engender a something special often unseen at the megabanks--the human touch. So to suggest--as Professor Marsh insinuates--that regional and community banks are a financial afterthought on the wane is simply incorrect.

Professor Marsh is quite correct that the number of smaller community banks decreased between 1985 to 2010, but her reasoning is wrong. Well-run community banks were often purchased well above book value by larger regional and megabanks because acquisitions proved to the most efficient way to grow profitable customers; it was certainly faster than growing them organically. Thanks to banking deregulation in the mid 1980's it became easier for the banking industry to consolidate--and it did in a hurry. Put another way, if community and regional banks lacked value, nobody would have purchased them. If this were the case, you could still bank at the Hibernia Branch that Patty Hearst once robbed.

Why? When you look at smaller regional and community banking in the aggregate, their average customer tends to be older, more financially stable, and their balances in core checking products is roughly twice as much products when compared to the megabanks. These are the type of clients that bankers want.

This is not to say that all community banks are well run or as fully capitalized as I would like to see. A number of smaller community banks were swept under with the failures from the Panic of 2008 but in no way did those losses come close to the asset value destruction from institutions like Washington Mutual, IndyMac, and the near failure of Wachovia, which together nearly torpedoed the American economy.

In 1985, roughly 25% of all deposits were in small to midsize regional or smaller community bank institutions. Today it is half. However smaller banks like Sovran Financial, South Shore Bank, First Florida, and many others have rolled up into to the portfolio of larger banks through acquisition, like Bank of America.

Professor Marsh also mentions that the reduction of deposits in smaller community banks spells trouble ahead. Not so fast. Using gross deposits as a simple yardstick can be a misleading metric when it comes to gauging the overall health of a community or regional bank. Depending upon the bank's rate strategy, in many cases, a smaller bank can be a more profitable bank. In times of lower rates--like what we are currently experiencing--banks will gladly bleed off expensive deposits (i.e.: CDs) in favor of acquiring fee-based non-interest checking.

What Professor Marsh should have done is to take a look at a number of other factors that drive bottom line profitability. First, I would want to better understand a bank's net growth in customers, specifically business customers. Considering that the average checking relationship lasts for 5 years, the ability to drive long term loyalty is the stickiness that will serve any bank well.

Second I would want to know the bank's ability to drive sustainable growth in Non-Interest income (NII) through a variety of fees. The ability to grow revenue through services rendered communicates to me that these customers understand the value offered by their regional or community bank.

Third, I would want to know how many of these customers use their community banks as their Primary Financial Institution (PFI), which essentially determines which banking relationship runs their lives. In the days of free checking, there were a lot of small balance checking accounts that sat and did nothing and these inactive accounts often nibbled away at a bank's balance sheet. The metric is easy enough to create. If a customer generates 20+ transactions per month from a variety of banking products, a bank can consider this client to be a PFI customer, even though he might have higher balances elsewhere.

Now that we have some distance between the present day and the banking crisis that led up to the Panic of 2008, I wanted to spend some time thinking through the current state of regional and community banking and offer my own thoughts of where things will head in the future.

The regional and community bank model is not without its weaknesses. While they tend to cater to wealthier (and profitable) clients community banks often lag behind the larger banks when it comes to the latest and greatest in technology. There are often geographical limitations to a regional or community bank's reach. Conversely if I am a Bank of America client in Atlanta, I can still get the same access to my accounts if I walked into a branch in Manhattan or San Francisco. Third, regional and community banks always worry about the transfer of generational wealth. Because children may not have the same loyalty to the smaller institution as their parents, generational wealth has a larger chance to flow away from a community institution when one generation meets their mortal coil. Since the demographics of community and regional banks skew older, that is something that will have to be forefront when banks plan for their growth initiatives.

However, technology may mitigate much of that concern. Since debit products have universal acceptance, you can spend to your heart's delight from your regional and community bank. Since these banks also have online banking and bill pay functionality (while not as pretty as the megabanks) you can manage your relationships from your laptop or tablet. Finally, since a number of smaller banks are adopting programs that allow you to deposit checks through a Smartphone phone, the days of lugging yourself down to a branch or to a distant ATM will soon go away. You can be in Bangor, Maine, thousands of miles away from your local community bank, and run your life as if it was around the corner.

Every big bank began life as a community bank. Even Bank of America, which was founded under the name of Bank of Italy, offered immigrants a banking experience that was denied to them by the white-shoe banking establishment of San Francisco. Even though the bank founded by AP Giannini was gobbled up long ago, the brand "Bank of America" continues today as a monument to acquisitions and empire building, but the name that built the brand was done one customer at a time.

In fact, I would not be surprised that as the economy improves, larger banks will soon reappear to scour the countryside for smaller and profitable regional and community banks to purchase for reasons articulated in the paragraphs above. To that end, community and regional banks will continue to add tremendous value to the American fabric.