The Great Bank Shakeout

Community banks failures offer an opening to the small lenders that survive

Back Longreads Jun 30, 2015 By Steven Yoder

Many nonprofits struggle along for years, trapped in an underfunding orbit. Without the money to grow, they stay too small to pay for things that attract attention and donors, like good program evaluations, updated equipment and technology, and savvy public relations.

That’s the position in which Children’s Choice for Hearing and Talking found itself in 2007. The school, based in Rancho Cordova, started in 1996 to serve deaf and hard-of-hearing children through third grade, renting space in a tiny, run-down church.

The staff put in dividers, but kids in class could hear noise from the classroom next door or water running in the restroom, says executive director Laura Turner. The nerve center of the program, the speech therapy rooms, sat right next to the main activity room, so conducting therapy sessions during music lessons or gym class became impossible. Background sounds “might not seem like a big deal in a typical environment,” says Turner, but they’re a huge barrier for hearing-impaired children learning to listen and develop spoken language.

Those space problems stifled the program’s growth. It plateaued at 20 children then could grow no more. It was past time to make a move, so Turner found a former daycare center on the market that would be perfect. It already had children’s restrooms, a kitchen and classrooms — but CCHAT would need a half-million-dollar loan to buy it.

The organization tried its own bank first — a big lender with a local branch — but was turned down flat. “Basically we were told, ‘Look, you’re not in a financial position to do this. The risk is too high,’” Turner says. A second big bank rejected their application, too. At that point, “We wondered how we were ever going to do this,” Turner says.

The number of banks fell from about 18,000 in 1984 to about 7,000 in 2011. While the largest banks grew elevenfold in that time, the number with less than $25 million in assets dropped by 96 percent. In that period, 18 of the 23 Sacramento County-based community banks closed or merged.

Then CCHAT’s real estate agent urged Turner to try a smaller local bank, suggesting West Sacramento’s Community Business Bank. He set up a meeting, and to Turner’s surprise, she found herself sitting across from bank CEO John DiMichele, not a loan officer. DiMichele didn’t say no in their initial meeting. Even better, he wanted a closer look at the program and came out for a visit.

A few weeks later, she got a call: DiMichele wanted to visit the program again to make a contribution. Turner thought that meant CCHAT wasn’t getting the loan and that the donation was a substitute. But after announcing the gift, DiMichele told them they were also getting their loan. The staff and kids all cheered and clapped.

The move to the new space transformed the program. Suddenly donors and school districts believed in CCHAT’s durability. Today the organization serves more than 70 children, its fundraising has tripled and the operating budget is up almost 80 percent.

Community banks — lenders with less than about $1 billion in assets — make the loans that bigger banks usually don’t. With about 10 percent of total banking assets, they’re the source of almost half the nation’s small-business loans and 43 percent of its farm loans. New regulations and low interest rates have shut down many smaller banks or forced mergers, but the survivors say they’re poised to take advantage of market openings and an improving economy.

Advantage to the Nimble

When doling out loans, small banks say they look beyond the numbers, like the coach who spots the next unrecruited star by assessing intangibles. That means considering elements like the nature of the enterprise, anomalies in the local market and the business owner’s reputation. Nuanced understanding in hand, small banks often can make the undersized loans that bigger players won’t touch. For large institutions, small loans don’t pencil out, says David Haithcock of the California Community Banking Network, a trade association. Every loan has administrative costs, and it’s pricier to make many small loans than fewer big loans. Small loans are community banks’ stock in trade, so they’re willing to manage the extra cost and dig deeper.

Community banks have long touted their edge in being able to turn on a dime. About a year ago, a customer came to one of them — Sacramento’s Merchants National Bank — looking for a mortgage. He’d found a house he wanted to buy, but the seller wanted to move quickly. Merchants approved the loan in 15 days, versus the standard 45 to 60, says bank president Stephen Meyers. “I don’t know of many lenders that could turn around a residential loan in that time frame,” he adds.

They also treat borrowers like partners, says DiMichele. That means he consults with clients on everything from business and cybersecurity to market risks. Haithcock calls regional banks an essential hub for keeping a community’s money at home since they pay out on local deposits and make local loans.

Beyond anecdotes, inter-country studies indicate that community banks spur small businesses, which employ half the U.S. workforce. A 2014 study by the Bank of Finland found less lending to small and medium-sized businesses in countries where banking is dominated by major players. Research in Canada in 2013 found that small and medium-sized businesses get lower-quality services in that country’s highly concentrated banking sector. The FDIC sees community banks as vital enough that it’s funded an entire division dedicated to supporting the sector with new initiatives and research.

Higher Costs, Lower Margins

None of that has spared small banks from the merciless winnowing that’s gone on the last 30 years. The number of banks fell from about 18,000 in 1984 to about 7,000 in 2011. While the largest banks grew elevenfold in that time, the number with less than $25 million in assets dropped by 96 percent. In that period, 18 of the 23 Sacramento County-based community banks closed or merged.

Investors wanting to launch a community bank once had to come up with $10 to $15 million. Now that number is $30 to $50 million. That, of course, limits the funder pool. Exactly two new community banks have opened nationwide since January 2011, according to the FDIC. In that period, more than 1,100 have shut down.

New regulations have raised their costs. The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act has gotten the most attention for creating compliance cost hikes. It’s set new requirements for mortgage lending that restrict flexibility and make it easier for lenders to be sued for failed home loans, for example. But tougher federal rules affecting small banks go back further. The 2001 USA Patriot Act required increased scrutiny of depositors, notes Robert Flautt, president of Folsom Lake Bank. Those and other mandates sliced chunks out of small banks’ earnings. Compliance costs at Folsom Lake Bank have increased $150,000 a year since it opened in 2007, Flautt says. Nationally, a 2014 survey found that more than a quarter of community banks expect to hire additional staff to comply with the new Dodd-Frank rules.

And while low interest rates have been the booster rockets for the rest of the economy, they create a drag on bank revenue. The net interest margin — the difference between what banks charge on loans and pay on deposits — has gone from 5 or 6 percent to 4 percent or less, says Flautt. In his bank’s case, that squeeze means a drop of a million dollars per year in revenue. While the crunch affects the whole banking sector, community banks are more vulnerable because they rely less on fees than do bigger banks and therefore need a healthy interest margin to stay solvent.

All of that favors those with economies of scale. Investors wanting to launch a community bank once had to come up with $10 to $15 million. Now that number is $30 to $50 million, says Edward Carpenter, chairman of the Irvine-based Carpenter & Co., which has organized the startup of more than 700 banks nationwide. That, of course, limits the funder pool. Exactly two new community banks have opened nationwide since January 2011, according to the FDIC — AloStar Bank of Commerce in Birmingham, Ala., and Bank of Bird-in-Hand in Bird-in-Hand, Penn. In that period, more than 1,100 shut down.  

Survivors Fill the Gap

Those that have kept their doors open are running leaner and have slashed costly business lines. Flautt says his bank needs 27 staff but has just 26 and won’t fill the remaining position.

At least two local banks — Folsom Lake Bank and Five Star Bank — also have trimmed by shutting down their mortgage lending divisions because of Dodd-Frank’s higher compliance costs. “We’re similar to most small businesses in leading with cost-cutting rather than revenue generation,” Flautt says.

Others are keeping their mortgage line running by managing compliance costs differently. DiMichele says Community Business Bank has outsourced a lot of the extra work and invested in new technology to streamline reporting. They’ve also put effort into good communication with their regulators to figure out their “hot buttons” — things like the quality of the bank’s commercial loans or of its internal controls to catch fraud. He says that helps the bank focus resources on the risk factors that regulators worry about most.

Some of the remaining banks also will look to merge with bigger partners. Community bank numbers in Sacramento have dropped mostly because of consolidation, says James Beckwith, CEO of Sacramento-based Five Star Bank. There will be more mergers where those came from in the next two years, he says.

The future isn’t all cutting and consolidating. With the economy recovering, banks are generating more revenue. As some have closed and merged, they’ve opened up space for the remaining ones. “From a customer acquisition standpoint, we’re better off than 10 years ago,” Beckwith says. Last year, Folsom Lake Bank saw its best loan growth — 20 percent — since opening eight years ago.

With about 10 percent of total banking assets, community banks are the source of almost half the nation’s small-business loans and 43 percent of its farm loans.

Plus, the Federal Reserve can’t keep clamping down on interest rates forever. When they rise, banks will see improved net interest margins, says Carpenter. He’s betting on that. Carpenter & Co. is working on community bank startups in two or three states.

Meanwhile, the federal government may soon ease some Dodd-Frank requirements on small banks. Rule changes proposed in January by the Consumer Financial Protection Bureau could provide community banks more safety from mortgage-related lawsuits and would expand the bureau’s definition of rural marketplaces to give more small banks flexibility in issuing home loans.

Those on the borrower side can only hope all of that changes the trajectory for community banks for good. Back at CCHAT, Turner says Community Business Bank long ago ceased to be just a lender; now it’s a key supporter. The bank connects Turner with potential donors, has a representative serving on her board and holds twice-a-year fundraisers for the program, she says.

When DiMichele talks about the school, the bank’s engagement value becomes clear. Community Business Bank gains something that goes beyond a financial arrangement: “It’s just satisfying when you see things like [the school] that create this value to you, and you’re actually making a difference some place.”

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