The Future of Community Banking

It’s natural to focus on immediate challenges such as compressed margins, liquidity issues, or underwater bond portfolios in this current environment. But despite the uncertainties and challenges of recent years, community bankers remain resilient, seeking ways to position their banks to maximize shareholder value and meet the needs of their communities.  

Where is the industry headed when the industry gets past the current issues burdening banks nationwide? Here are our thoughts on the three major shifts in community banking that we foresee on the horizon.

Consolidation

Consolidation within the banking industry has been predicted for the past 35 years, and in some sense that indeed has occurred. According to FDIC data, the U.S. has transitioned from approximately 14,600 commercial banks in 1980 to approximately 4,100 in 2022, with 13,637 unassisted mergers (mergers not caused by a bank failure) occurring over the period. But even that 70% decline falls short of what experts were predicting at the start of this consolidation trend.

While predictions of mass consolidation have partially materialized, community banks' competitive advantages, such as local economic expertise and personalized service, have preserved their independence. However, a lack of succession planning poses a challenge to that independence.

With the post-pandemic landscape revealing new challenges like inflation and rising interest rates, many banks may seek an exit once the M&A market stabilizes. Particularly, once interest rates stabilize, currently underwater bond portfolios recover, and the publicly-traded bank stock prices return to a more normalized level, we could be in for a flurry of consolidation as banks try to time their exit before additional challenges arise.

Community banking franchises planning an exit should initiate discussions with potential acquirers and craft compelling narratives about their bank to maximize shareholder value when the time comes to sell. Conversely, banks aiming to grow through acquisitions should maintain a diverse target list to make informed and timely decisions.

Imagine a salesperson who has only one large deal in their pipeline. Perhaps if they hope, pray, and sacrifice enough of the business’s profitability on the deal it just might close by quarter end, and they will achieve quota. Similarly, some acquirers have eyes for only one idyllic target that they would love to buy if given the chance. This is a limited and often unsuccessful way to approach community bank M&A. When your pipeline is chock full of potential targets, it’s far easier to walk away from a bad deal.

Community banks seeking growth opportunities through acquisition should also be engaged in periodic communication with investment bankers. For example, when American State Bancshares sold to Equity Bancshares in 2021¹ , the target’s advisor reached out to Equity Bancshares’ management team to bid because Equity Bancshares previously had expressed interest in acquisition opportunities to the advisor team.

Meanwhile, American State Bancshares had defined the merger requirements for an acquirer through previous informal discussions with potential buyers which led to a limited pool of acquirers that were deemed to be of interest by the board of American State Bancshares.

The seeds for the merger’s success were sown years prior to either party engaging in discussions with each either because of the proactive actions of both the banks’ management teams.

¹ From the June 14, 2021 article by Leo Gatdula, “American State Bancshares board sought merger partner with stock upside” published by S&P Global Market Intelligence. 

Technology  

We previously discussed the competitive advantage that community banks boast via their ability to provide exceptional customer service. But technology and shifting demographics can challenge this customer service advantage. If regional banks and/or fintechs could provide a comparable degree of service (and faster) at a fraction of the overhead cost by leveraging technology, what would this mean for the competitive advantage of community banks?

In a 2023 survey conducted by Bank Director, only 55% of respondents claimed that a small business could fully complete a digital loan application today. As technology reshapes customer expectations, community banks must enhance their digital banking capabilities. To compete effectively, banks will have to invest in digitally native products and services.

As the hysteria and euphoria of a zero-rate environment gives way to reality, many of the Banking-as-a-Service and fintech platforms are struggling to stay afloat now that capital is significantly scarcer. Those that do survive this environment will have done so because they found a viable market for their product. Now is the time for community bankers to investigate these platforms and the technology that they can leverage to improve their ability to provide fast and exceptional service to their customers.

Community banks that are successful in executing a digital transformation, whether by building it themselves or forming the right partnerships, will be well positioned to serve the customers of tomorrow.

The ones that don’t will likely be a part of the fold seeking an exit.

Regulatory Environment

Clients have recently shared accounts of regulatory examiners reviewing the stress testing of various portions of the banks’ balance sheet. After the regulators had reviewed the stress tests, they asked for more stress testing.

“Well, how much more?” one banker asked.

“Just more,” responded the regulator.

Regulators are worried, and perhaps rightfully so to some degree. They got caught napping when Silicon Valley Bank collapsed and now the rest of the appropriately-risked banks will bear the consequence as the proverbial tail of safety and soundness wags the dog.

However, this is nothing new in the banking industry. Every major crisis leads to the enacting of regulatory policies that swing the pendulum in the other direction. Policies are then slowly loosened as the fear and panic subsides. In the meantime, bankers must endure stronger regulatory pressure. We predict that this low tolerance from regulators is going to make it especially difficult for banks under $500 million in total assets.

In contrast, we believe that a more effective regulatory approach would involve reducing barriers to entry for smaller banks. By doing so, more community banks could be established, fostering healthy competition. This increased competition would naturally eliminate weaker players and those with insufficient capital, ensuring a stronger and more stable banking sector.

However, we cannot predict that to be the case. The more likely scenario is that regulators’ heightened scrutiny will lead to increased costs for community banks. 

Conclusion

Community banks are in a phase of adaptation, navigating challenges such as interest rate risk, moderating loan demand/risk appetite, technological advancements, and regulatory pressures. The industry's future hinges on how swiftly digitalization occurs, the potential wave of M&A activity, and the regulatory environment that is imposed by future administrations. These factors will redefine the competitive advantage of community banks, setting the stage for a new era in community banking.

M&A Thoughts

As discussed in a prior edition, acquirers closing deals in today’s interest rate environment often must absorb sizeable unrealized losses associated with the securities portfolio of a target bank. The securities portfolio is “marked to market” with the closing purchase accounting adjustments. While the unrealized loss is recouped (accreted into income) gradually over the life of securities, a significantly larger level of intangible assets (purchase price in excess of net tangible assets) is recorded than otherwise would have been the case had the transaction occurred prior to rising rates and the deterioration in the market value of the target bank’s securities portfolio.

The good news is that in today’s interest rate environment, the value of core deposits are markedly higher than they were in a lower rate environment. Thus, acquirers can book a significantly larger Core Deposit Intangible (“CDI”) than otherwise would have been the case had the transaction occurred prior to rising rates and the deterioration in the market value of the securities portfolio. This, in turn, diminishes goodwill (a non-amortizable intangible asset) that remains on the acquirer’s book until, and if, impaired. The CDI on the other hand is amortized over the life of the deposits.