mark-sunshineLast week CFA’s blog featured Chairman & CEO Mark Sunshine of Veritas Financial Partners. Here is Part I of Sunshine’s piece on why “Bigger is Better When It Comes to Banking” and here is Part II. Below is Part III of the series.

Someone once said: “The definition of stupidity is doing the same thing over and over again and expecting different results.”

Apparently, small bank executives and regulators have never heard of this quote.

Year after year, community bankers and their regulators continue to do the same things that they do, and then cannot understand why they get the same poor results. Sticking to the old play book is causing community banks to slide into economic irrelevance.  If things are going to change, a new approach to community banking is needed.

The problem is that small banks do not generate enough non-interest revenue, and they spend too much on overhead

Most small banks cannot figure out what to do to get their customers to want to pay them fees for the services they have provided. As a result, small banks remain highly dependent on interest income as their primary source of revenue.

On the other hand, big banks generate high amounts of fee income. In fact, according to the FDIC, big banks generate, on average, twice as much fee income relative to assets as their smallest competitors.

Making things worse, small banks spend too much on non-interest expenses relative to their larger competitors. Virtually every small bank executive knows why his costs are out of control. Small bank executives uniformly blame high expense ratios on the cost of complying with regulations.

Community bankers have a point when they point to regulators as a primary source of their problems. Since the beginning of the financial crisis, virtually all regulatory policy options have increased the costs of regulatory compliance and put small banks at a competitive disadvantage relative to big banks, which can more easily absorb such costs.

Small banks have been caught between a proverbial “rock and a hard place.” If they comply with banking regulations, they cannot make money, and if they do not comply, they will be disciplined by regulators.

Instead of figuring out a new way to comply and make money, community bankers have retreated and restricted their products, which has made them less competitive to customers.

Small banks can still turn it around if they work to “raise their game” by going on the offense and offer high margin commercial banking products and services. And, yes, regulators can help. Regulators need to provide safe harbor alternatives for small banks to reduce compliance costs by pooling resources and operations and loans and deposits.

All is not lost for community banks. There is still time for community bankers to raise their game and offer high margin products and services without getting into the regulatory dog house. The quickest way that community banks can change their fate is to expand their business banking products and services.

The problem is that individually, most small banks do not have the resources to expand their business banking offerings. But, if they pool their resources, they will have plenty of fire power to be successful.

Below are three simple policy and operating options that small banks and their regulators can do right now to turn things around.  However, bankers cannot do it by themselves. Regulators need to help by providing guidance and safe harbors to small banks.

Reduce barriers to commercial asset-based lending by outsourcing back and middle office services

Asset-based commercial lending is a very high margin big bank product, but it is almost completely absent from small banks. In addition to generating high levels of interest income, asset-based loans produce vast amounts of non-interest income and cheap deposits. And, because of the relatively large size of asset-based loans and their high earnings rate, the asset-based lending has an almost immediate material positive impact on earnings.

So, why don’t more small banks participate in asset-based lending?

It is because of regulation.

Approximately thirteen years ago, the OCC issued new and strict asset-based lending rules that raised back and middle office operational standards beyond the then standard of most small banks. As a result, small banks simply withdrew from the market.

The thirteen year old OCC rules are still in effect, and now there are only a handful of community banks that make asset-based loans. For the vast majority of small banks, asset-based loans are something done by others.

Simply put, community banks need to get back in the asset-based lending game; but in compliance with OCC regulations.

So what is holding back community bankers? First, bankers are like other people, and they like to operate in their comfort zones. Asset-based lending is not something that is familiar to them anymore, and they are reluctant to change.

Second, bankers are afraid of their regulators. If the OCC and FDIC want community banks to be relevant, they need to help community banks by providing regulatory certainty for new activities that are both profitable and safe and sound.

To ensure compliance with OCC and FDIC regulations, community banks need to outsource back and middle office operations to servicers that comply with regulations without fear of regulatory criticism. With appropriate back and middle office servicing in place, small banks can get back into the business of profitably serving lower middle-market commercial borrowers in their local communities.

Sharing of Deposits

Asset-based loans are high powered deposit gathering vacuums. Asset-based borrowers almost always need high margin deposit and transaction services, and because their deposits are often larger than the $250,000 FDIC insurance limit business, depositors often keep their accounts at large institutions.

Regulators can solve this problem without increasing deposit limits by allowing for deposit syndication and sharing between small banks. Through deposit syndication programs, funds in excess of $250,000 can be split up between banks so that the aggregate amount on deposit in any one bank does not exceed $250,000, and is therefore fully insured.

There are existing deposit syndication programs such as the CEDERS and FICA programs, but those programs have limited applicability.  To comply with regulations and to not be classified as brokered deposits, they are cumbersome to use. On the other hand, if shared deposit programs are easy to use, they get the regulatory taint of being “brokered deposits”.

If regulators help design programs that are both easy to use and aren’t classified as brokered deposit programs, middle-market commercial depositors will once again be able to use their local bank as a primary depository without fear of having uninsured deposits.

Syndication of Loans

Small banks have small legal lending limits, and the problem with small banks doing commercial lending is that the best credits in their local markets are often too big for them. The obvious solution is to have small banks pool their resources through the purchase and sale of loan participations.

The purchasing of loan participations by small banks has been discouraged by bank regulators for many years. However, unless small banks have the ability to syndicate business loans, the best and most profitable business credits will remain off limits.

Small bankers all know what regulators do not like about loan syndications, but no one surely knows what regulators like. Banking regulators can encourage the sharing of credits by publishing clear and definitive safe harbor rules for loan sharing by community banks.

If community banks are to survive, community bankers need to reestablish themselves as the “go to” place for small business, and regulators have to help by providing regulatory certainty for bankers

Small banks and their regulators need to get out of their comfort zones, and they need to stop repeating the mistakes of past years. By cooperating on operations, lending and deposits, small banks can neutralize the advantages of large banks and capture high margin commercial customers. However, for community banks to change, regulators need to take the lead and provide guidance, training and regulatory certainty. Without change, community banks and small banks will continue their slow slide into economic irrelevancy.

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