ByTimothy J. Yeager
The United States is unique among industrial countries for the ubiquity of its community banks, loosely defined as those that have less than $300 million in assets and are not owned by a large bank holding company. In fact, the United States has more community banks per capita than any other country in the world. Recent changes in our banking environment, however, threaten the long-term viability of these institutions. Rapid advances in technology have given financial services customers more options than ever before. At the same time, branching restrictions that once kept larger banks at bay have been eliminated, allowing head-to-head competition. While community banks continue to offer a valuable commodity—personalized service—the size of their market niche will depend on their ability to monitor overhead expenses, develop innovative products and services, and employ modern strategies for managing risk.
It's no secret that community banks' personal relationships with their customers are key to their success. Many depositors prefer human tellers to ATMs and value the relationships they develop with bank staff through repeated transactions. As a result, the bank can rely on a large, stable base of core funding that is relatively insensitive to market conditions. In terms of lending, community banks maintain an edge in originating small business loans, for which little public information about the creditworthiness of the borrower is available. Intangible information, such as an entrepreneur's reputation in the community, is obtained more easily by a community banker. Likewise, because loan officers at small banks are closer in the chain of command to senior managers, they generally deal with less bureaucracy and, therefore, have more discretion in lending with "exceptions." They may also be more flexible in tailoring their loan policies to small business customers. These advantages help community banks remain competitive in a market in which substantial economies of scale and scope allow larger banks to offer more attractively priced options.
While personal service is undoubtedly a valued commodity, there is a trade-off between service and price. The convenience and affordability of large bank products tempt customers who put less value on personal service. Unless community banks find a way to compete, they will continue to lose market share to larger banks. In 1983, community banks held one-fourth (as measured by assets) of the banking industry's market share; by 1998, that share was just one-eighth.
To remain competitive, community banks must find a way to trim overhead costs. Small banks, especially those with assets less than $100 million, have efficiency ratios several percentage points higher than those of larger banks. This is due, in part, to the relatively high personnel costs related to personalized service. One solution is to generate additional fee income by offering customers new products, such as trust, brokerage and financial planning services.
Community banks must also modify their approach to risk management. In the past, credit risk was a community banker's greatest concern. Today, these banks face a more complex array of risks. For example, many community banks have turned to Federal Home Loan Bank advances to offset the recent dearth of core deposits. These funds, while useful for managing net interest margins, potentially expose the bank to greater levels of liquidity and market risk. Other community banks are tailoring mortgage loans to their customers' needs by reducing the amount of equity required to eliminate mortgage premium insurance. Such loans cannot be securitized, which may increase a bank's exposure to interest rate risk. To compete successfully with large banks without compromising safety and soundness, community banks will need to devote additional resources to measuring and monitoring these risk exposures.
The rules of the game are changing for community banks. Their role in the future banking environment depends upon their ability to innovate and simultaneously manage new types of risks.