Two recent federal banking agency reports show very different pictures of the banking environment for community banks.  In “Too Small to Succeed? – Community Banks in a New Regulatory Environment,” the Federal Reserve Bank of Dallas lays out the “apparent” rising regulatory burden confronting banks today.  In contract, “Financial Performance and Management Structure of Small, Closely Held Banks,” published in the FDIC Quarterly, provides an empirical analysis of the success of closely held community banks in the FDIC Kansas City, Dallas and Chicago regions.

Lots of Community Banks Remain

As a reminder (which often seems forgotten in these discussions), the U.S. banking industry is still full of community banks.  As of December 31, 2015 (the latest data available), there were 6,182 insured depository institutions in the United States (banks and thrifts, exclusive of credit unions).  Only 107 of those institutions had more than $10 billion in assets; 595 institutions had between $1 and $10 billion, 3,792 had between $100 million and $1 billion, and 1,688 had less than $100 million in assets.  (That’s not to say there isn’t significant concentration; the 110 institutions over $10 billion in assets hold over 81% of the assets in the industry.)

As indicated by the otherwise down-beat Federal Reserve paper, community banks (measured as having less than $10 billion in this analysis) have still maintained 55% of all small-business loans and 75% of all agricultural loans (and banks under $1 billion in total assets still provide 54% of all agricultural loans).  As pointed out by the Federal Reserve paper, community banks accounted for 64% of the $4.6 trillion of total banking assets in 1992, but accounted for only 19% of $15.9 trillion of banking assets in 2015.  While we have certainly had consolidation (both fewer banks, and larger banks), the community bank’s aggregate market ownership has, based on the Federal Reserve’s percentages and totals, actually gone up slightly from $2.9 trillion to $3.0 trillion.

Measuring Regulatory Burden

As a proxy for measuring the regulatory burden on community banks, the Federal Reserve paper notes the length of Call Reports and the physical size of banking legislation adopted each year.

The growth in Call Reports (or possibly more so just how small they used to be) is staggering.  From four pages in the 1950’s, and a total of 70 items in 1970, to 84 pages and 2,379 items, the change is staggering.  However, let’s not forget that technology has certainly evolved over that time period as well, as most of us now hold significantly more processing power than the Apollo moon rockets had, since an iPhone 6S is about 200,000,000 times more powerful than the Apollo guidance computer.  If one takes into consideration the effects of Moore’s law (and assume banks have kept up with technological innovation – which we all know is a perfectly reasonable assumption), the Call Report should take significantly less time to complete now then it did in the 1950’s!

Similarly, I’m not sure that the length of banking statutes (or perhaps better stated as the absence of brevity) necessarily indicates more regulation as much as it suggests that how a bill becomes law is more complicated than how I was taught by School House Rock.

While on one hand I find the Federal Reserve’s use of Call Report and statute length to be a poor (or at least overly simplistic) proxy for regulatory burdens, as suggested by the Federal Reserve, such data may actually “be a meaningful proxy for the hard-to-measure, latent requirements that regulators have placed on smaller banks.”  For many of our clients, we have found that that the increasing regulatory burdens are not found in specific provisions of the Dodd-Frank Act or BASEL III, but rather in the aggregate, and potentially overwhelming, breadth and depth of regulatory oversight along with the near constant evolution of guidance and rules, whether or not they directly apply to the bank’s activities.  As the Federal Reserve paper accurately points out, the average community bank is less able, without significant hits to profitability, to increase staff to track, much less comply, with ever involving regulation.

To that end, we fully agree with the Federal Reserve’s conclusions that “regulatory oversight should match the level of risk an institution poses to the financial system and economy at large.”

However, we also think that Robert Sarver, Chairman and CEO of Western Alliance Bancorporation, had a great point in his remarks on the CEO round table at Bank Director’s Acquire or Be Acquired conference earlier this year.  Robert’s advice to the industry with regard to Dodd-Frank and regulatory burdens: “Quit your whining.”  Bank regulation is the trade-off for being allowed to have government deposit insurance backing a fundamentally cheap funding source, and has been part of the industry since the invention of said insurance.  Rather than just yearn for the better days of yesteryear (when, bankers were yearning for the better days of even earlier years), the industry needs to do what it has always done in the light of regulation… continue to adjust and evolve.

Financial Success of Community Banks

In that regard, the FDIC study provides further evidence that the smallest community banks may continue to thrive.  As found by the FDIC, closely held banks in which the manager is a member of the ownership group, or is another insider, outperform both closely held banks with no overlap between ownership and management and widely held banks.

The FDIC study looked at community banks in the Chicago, Dallas and Kansas City FDIC regions.  The report was based on voluntary survey results, and thus doesn’t necessarily reflect a random or representative sample, but the results are still instructive (and consistent with our long term experience).  Of the 1,357 community banks in the region that responded to the survey, 75% were closely held.  Extrapolating from the concentration numbers above, it’s reasonable to extrapolate that closely held banks are the norm rather than the exception throughout the entire industry.

The FDIC study further identified that in banks with an identifiable primary owner or ownership group, that group tended to take an active role in management of the bank.  In almost all of the closely held community banks, members of the primary ownership group were directors of the bank, and in almost 60% of such banks, the “key officer” running the institution was also a member of, or closely affiliated with, the primary ownership group.  This unification of interests between management and the shareholders greatly reduces principal-agent problems while also aligning the risk/reward spectrum.  Although this connection between primary ownership group and management could be expected to have a detrimental effect on succession planning, the FDIC study generally found that succession planning concerns were in line with widely held community banks (which is to say still a significant challenge, but no more so for closely held banks than widely held banks).

In the FDIC’s study, closely held community banks tended to be smaller, more rural, and with a larger agricultural focus than widely held banks.  Closely held community banks averaged $264 million in total assets, compared with $364 million for widely held community banks.  36% of closely held community banks were headquartered in rural counties, versus 21% for their widely held brethren (and the closely held community banks were also significantly more likely to be headquartered in rural counties with negative population growth – 21% vs. 10%).  Consistent with this geographic footprint, closely held banks were nearly twice as likely to engage in agricultural lending, and less likely to engage in mortgage lending or multiple lending areas.

Despite these apparent demographic disadvantages, the FDIC study also found that closely held banks, particularly those with management overlap, significantly outperformed widely held community banks.  From 2009 through 2014, closely held community banks with management overlap earned a return on assets 21 basis points higher compared with closely held community banks with no overlap, and over 30 basis points higher compared with widely held community banks.  Closely held community banks with management overlap also had a materially better efficiency ratio than either closely held community banks without management overlap or widely held community banks.  While one might presume this could be due to a shifting of management income from salary to dividends, the FDIC study in fact found that closely held banks with overlap of management and ownership actually reported higher salary expense as a percentage of average assets in each of the past six years.  However, higher levels of noninterest income and much higher loan yields more than made up for this salary expense disadvantage.

Conclusion

The FDIC study is fully consistent with our long term experience advising closely held community banks.  They tend to be more stable as they are focused on current year (and sustainable) profits and dividends rather than growth for growth’s sake.  They are also highly attuned to risk, as they “playing with their own real money.”  As one CEO of a newly Sub S institution mentioned to us, “every month I see my share of net income instead of just numbers on a spreadsheet.”  While we are likely to continue to see industry consolidation as presented in the Federal Reserve report, the FDIC study would also seem to confirm that there’s a continued, and profitable, role for closely held community banks.