denovobanks.com - the premier resource for existing and prospective de novo banks

Ten Challenges Facing Community Banks

JIM KOLTVEIT AND JOHN P. OWENS

Consider the banking industry’s recentrecord: • Nationwide banks have been created. • An insurance company and a bank holding company merged to form the nation’s largest financial services company. • The number of FDIC-insured banks declined by 19% from December 1993 to December 1998. • Even community banks now offer Internet access. As this short list of examples shows, every bank must be prepared for more change. To face the future, community banks must address 10 challenges.

LEVERAGING CAPITAL APPROPRIATELY

The banking industry went through some difficult economic times. In the 1980s, banks were failing, and capital was scarce. Now, the industry reports consistently high profitability, and capital is plentiful. For many banks, it is a major challenge to grow fast enough to leverage the increased capital generated by earnings. Unitary thrift holding companies can use dividends received tax free from their subsidiary federal savings banks for any purpose, so a unitary thrift holding company could diversify by investing in unrelated businesses. Bank holding companies that qualify as S corporations can manage capital levels by paying significant amounts of current income as dividends to their shareholders. This can be a good alternative for many banks. However, the current limitation of 75 shareholders makes this alternative impossible for many community banks with more than 75 shareholders. A change in the number of permissible shareholders to 150, as currently proposed in Congress, would be a significant improvement.

Availability of capital combined with restrictions on the ways a bank or bank holding company can invest capital have been contributing factors to industry consolidation. Banks and bank holding companies with excessive capital that cannot elect S corporation status have limited choices. They can: (1) continue to hold capital and increase capital levels; (2) distribute capital as taxable dividends; (3) buy a bank or bank-related business; or (4) some combination of the above. Buying another bank becomes the de facto choice when other options do not appear viable.

Ideally, loans and deposits would grow at the same rate. Unfortunately, that rarely happens. However, deposit growth can often be managed by changing interest rates: Low interest rates, compared to the market, result in slow or no growth; higher interest rates accelerate growth.

When deposit growth is easy to obtain, the challenge will be to find interest-earning assets that provide a profitable interest margin. Banks must know the incremental cost associated with new deposits. Although the goal will always be to find earning assets that produce returns to cover all costs, any earnings in excess of the incremental costs of the deposits Community Banking Ten Challenges Facing Community Banks JIM KOLTVEIT AND JOHN P. OWENS JIM KOLTVEIT is executive vice president, financial institutions and JOHN P. OWENS is director of strategic services with RSM McGladrey, Inc., St Paul, Minnesota, and Atlanta. Draft will increase net income. Consider, for example, $1 million in new deposits with an effective interest cost of 4.0%. If the direct costs of acquiring and servicing were the equivalent of 0.5%, an earning asset with an effective rate greater than 4.5% would produce some amount of additional net income. But don’t neglect the cost of converting existing deposits to a higher rate.

Banks must know the incremental cost associated with new deposits.

Alternate sources of funding may be needed when loans are plentiful, but deposits are not easy to obtain. Bankers in this situation will need to know the sources and costs of funding, in order to price loans appropriately. Currently, the primary alternative sources of funds are certificates of deposit, obtained from brokers or through posting services and loans from Federal Home Loan Banks. The cost of borrowing from the Federal Home Loan Bank may be higher than rates on deposits, but the processing costs are likely to be significantly less. Banks can also borrow funds from other sources. Mortgaging the bank’s real estate or pledging bank securities on repurchase agreements are also possibilities.

The challenge of appropriately leveraging capital is ongoing for every institution. Banks seeking high returns on assets often find it difficult to leverage capital, because adding incremental loans and deposits with lower interest margins reduces return on assets, even though return on equity increases. Consequently, return on equity is likely to become a more common measure of success than return on assets.

ADDING INSURANCE SERVICES

Many banks have been in the insurance business, either directly or indirectly, for years and have had marginal success. Even so, it is increasingly clear that insurance will be sold through banks or bank subsidiaries. Citigroup is the most obvious example, but other major bank holding companies also are selling insurance of all types. Community banks need to consider whether they should be in the insurance business and, if so, what types of insurance they should offer. Property and casualty, crop hail, and accidental death insurance are typical offerings of a community bank insurance agency. However, life, extended care, and disability insurance are significantly more profitable. If a bank offers insurance, it will need to determine the types of insurance to offer. A significant amount of focused effort would be required to make insurance sales a profitable operation.

COMPETING IN THE LOAN BUSINESS

Loans are the lifeblood of most community banks. Currently, however, banks originate less than 19% of all loans to business, down from 70% in the 1980s. As a result, lending is increasingly competitive. At one time, large banks seemed unable or unwilling to compete for smallbusiness loans. Today, many large banks are very competitive in the small-business-lending arena. They are using credit scoring and other technology to make smallbusiness loans quickly and easily. A bank that specializes in small-business lending needs to find a way to merge the high-touch community banking approach with the high-tech big-bank lending approach in order to create a value-added lending service for customers and prospects. Otherwise, the bank is likely to learn the lesson that thousands of mom-and-pop stores throughout the U.S. learned from Wal-Mart: Many customers value price and convenience more than familiarity and service. Mortgage loan margins continue to decline, to the extent that the largest originators reported net losses on origination, according to a 1998 industry study. The Internet has become the greatest source of disintermediation for every facet of the home-buying experience, from the purchase of the home itself to the financing. One speaker at the American Bankers Association Community Bankers Conference predicted that more than 50% of mortgage loans would be electronically originated by 2005.1

WATCHING FOR BUSTS IN A BOOMING ECONOMY

Economic conditions have been good for almost eight years. In fact, the Federal Reserve Board is worried that our economy may be too good. However, there are some disturbing signals.

Five large banking companies have recently reported significant increases in nonperforming loans and loan-loss provisions.

Year after year personal bankruptcies set records. Agricultural producers are concerned about long-term survival because of low commodity prices. Many businesses are having difficulty finding adequate numbers of qualified employ- 44 TEN CHALLENGES FACING COMMUNITY BANKS WINTER 2000 Draft ees, putting increased pressure on wages. In most parts of the country, a shortage of certain types of building materials and high demand caused housing costs to skyrocket.

On the other hand, the Southeast in particular, and Florida specifically, has enjoyed record home and condominium construction. Productivity continues to improve. Retail sales are good. Automobile manufacturers are expecting to produce near-record numbers of vehicles this year.

The last recession was distinguished by a series of regional downturns. Whether we will ever experience a period like that again is unknown, but bankers should be aware of the economic factors affecting their banks, their markets, and especially their loan customers. Banks must be prepared to deal with the consequences of negative changes in the economy and their customers’ economic circumstances.

IMPLEMENTING RISK MANAGEMENT

Bank regulators have spent considerable time and effort on risk management. Unfortunately, the regulatory approach has to be somewhat formula driven. The nature of banking is risk management—guaranteeing deposits and hoping to collect on loans and investments. Even so, very few bankers spend a significant amount of time thinking about, planning for, and managing risks. Ron Dembo, CEO of Algorithmics Inc., believes, “If you are not managing risk, you can’t claim to be managing your business.”

Very few bankers spend a significant amount of time thinking about, planning for, and managing risks.

In an interview in Fast Company magazine, Mr. Dembo says, “When it comes to risk, the most common error that people make is to think about the future in terms of a single scenario. Most business decisions are onetime events; thinking about probability doesn’t help much with those decisions.”2

He suggests you think about regret, the consequences that really would matter to you. For example, people might risk losing a house without much regret, but some would never recover from the tragedy of losing their home. Similarly, some people buy lottery tickets to avoid the regret of not having a winning ticket if their numbers were picked. Real risk management is managing to make sure that if something big goes wrong, you’ll still be covered.

Smart leaders always have a Plan B. Your bank and its key customers need a Plan B.

MAKING THE MOST OF TECHNOLOGY

No discussion of the future of the banking industry would be complete without considering technology. For most banks, technology is both boon and burden. The good news is that technology is generally affordable, readily available, and relatively easy to use. The bad news is that it changes rapidly, needs constant updating, and enables competitors to reach your bank’s customers.

Just a few years ago bankers questioned whether or not they needed to establish Web sites. In 1999, the ABA Community Bank Survey revealed that 42% of community bankers already had a site; 11% planned to develop one. At that time, community banks were offering the following functions on their Web sites:

information about the bank—94.0%;
community information—47.6%;
two-way e-mail—46.4%;
financial calculators—42.1%;
applications—16.0%;
account balances—25.3%;
bill paying—24.7%.

Obviously, very few community banks are using Web sites for interactive banking. Yet, the July–August 1999 edition of Bloomberg Personal Finance reported that the large banks and nonbanks are making significant investments in interactive Internet sites to allow customers to access bank accounts, brokerage accounts, and, through a single log-on, to navigate between them. Both Bank One and First Union have indicated that significant decreases in their branch networks will occur as a result of a concentration in either the Internet or other financial services.

In a July 1999 issue of The American Banker, several community bankers retorted that they felt the need for branches was still valid.

I believe that interactive Internet banking as an alternative and possible future replacement to branch banking should not be too quickly disparaged or dis-missed: Just ask the president of Barnes and Noble about the impact of Amazon.com.

There is still nothing as common in banking as a branch. In fact, according to the ABA Community Bank Survey, nearly one quarter of banks increased the number of branches they operated during 1998. For now, community bankers favor branches as the best way to reach out to old and new customers alike.

Increasingly, however, banks reach out to customers via electronic banking. The following electronic delivery services are ranked from most to least popular:

ATMs—offered by 91.7% of community banks;
automated clearinghouse—73.2%;
direct deposit—73.2%;
24-hour telephone banking (voice response)—63.3%;
point-of-sale terminals—40.1%;
non-Internet home banking—9.4%.

Note that telephone call centers are not recognized as an electronic banking channel. Based on RSM McGladrey’s observations, most community banks (in fact, most banks) have not used the telephone effectively. Telephone banking can be a powerful defensive weapon against large regional and national banks.

RETAINING CUSTOMERS THROUGH TECHNOLOGY

Large banks offer multiple locations across wide regions of the country, so a customer who moves, who spends the summer in cool climates and the winter in warm climates, or who travels extensively does not need to change banks.

Internet banking makes it possible for smaller banks without nationwide branches to compete. Of course, larger banks aren’t ignoring Internet banking, so even if your bank’s customers never move or travel, you may need to consider Internet banking as a defensive move. (Wells Fargo is reported to have almost 1 million customers who use its Internet banking system.)

Community bankers will need to continue to stay on top of technology developments and determine how to make technology work best for their banks. And, since technology is changing quickly, bank strategy should be developed with a maximum amount of flexibility, so new technology can be adapted quickly, conveniently, and economically.

RETAINING CUSTOMERS THROUGH NEW SERVICES

Community bankers claim to have an advantage over large regional and national banks: They know their customers and provide personal services based on that knowledge.

How much of this claim is a reality and how much is a fantasy in your bank? How well do you really know your customers? Do you actually know their incomes, where they have invested their money, their financial plans, and their future financial needs?

Banks are trying to compete with brokerage firms and insurance companies that offer financial-planning services by looking at an investor’s total financial picture. Can a bank effectively compete without offering a similar service? Community banks also must respond to their customer’s demands for alternative investments (despite their own concerns about declining core deposits) by introducing insurance, annuity products, and mutual funds.

In fact, according to a 1999 survey conducted by KPMG, 35% of banks polled intend to offer annuity products and 28% intend to offer mutual funds in the near future. In addition, this same survey found that more banks will focus on technology by introducing telephone banking (30%), debit cards (25%), and ACH origination services (24%). This survey, which has an error rate of plus or minus 3%, included 815 banks, of which 29% had assets of $50 million or less, 26% had $51 million to $100 million, and 45% had assets in excess of $100 million.

While some community banks have aggressive plans to introduce a number of products, many do not. Thirtyeight percent of community banks indicate they would not introduce mutual funds, 31% would not introduce insurance and annuities, and 27% would not introduce credit cards.

ACCEPTING NEW EARNINGS METHODS

Many of the current products offered by community banks, including one- to four-family residential mortgage loans, will see even greater declines in interest margins as disintermediation increases. The proper technology is becoming an imperative in this particular arena, with Freddie Mac and Fannie Mae’s loan origination systems virtually eliminating underwriters and loan processors, plus providing the customer with an answer immediately. Such technology has become the rule rather than the exception.

It is interesting to examine the financial profiles of community banks and compare noninterest income and expense levels. Generally, banks with high noninterest income also have high noninterest expense. These banks do not necessarily have higher returns on assets than banks with low levels of noninterest income.

This raises questions as to the profitability of the feeincome- producing services a bank offers. Banks will need to adopt and refine cost accounting systems that allow management to easily and effectively monitor contribution to net income of individual products, services, and customers.

KNOWING THE FACE OF THE FUTURE

Community bankers certainly face formidable challenges, but many are no different than those faced by their customers and by all of us. Any individual or business that meets those challenges will be well on the way to success.

Here’s what we can say about the future: Big financial organizations will become even bigger. Technology will play an increasing role in the delivery of bank products and services. Time is becoming more important. Convenience matters more than it used to. Bankers should expect competition from organizations that don’t even exist today. The value of brick and mortar will rapidly depreciate. Acquisition of bank locations will decline, as a result of alternative delivery channels.

Banks are not immune to the megatrends that are being established by the Internet. The Internet is forcing companies to transform themselves and to rethink their strategies, organizations, and business models. The extended enterprise concept of electronically networking customers, suppliers, and partners is now reality.

New channels are changing market access (in short, the entire customer experience) and causing disintermediation in traditional channels.
The balance of power is shifting to the customer. Customers are much more demanding than their nonwired predecessors. True customer loyalty is much harder to build.
The face of competition is changing. In addition to new competitors, traditional competitors are exploiting the Internet to become more innovative and efficient.
The pace of business is moving to warp speed.
The Internet is pushing enterprises past their traditional boundaries.
Knowledge is becoming a key asset and source of competitive advantage.

1ABA Journal, September 2000. 2Fast Company, February 2000.