Smaller Banks: A 'Legacy' Problem

by: John M. Mason


More and more smaller banks are being acquired.

Regulations and the state of the economy are driving this behavior.

Small commercial banks may just be a thing of the past.

Are small banks a thing of the past?

I believe they are... and there is a growing realization that this, in fact, is a reality.

According to the Wall Street Journal, "Small Banks Look to Sell," the banking environment has changed.

So have the statistics. On December 31, 2013, according to the FDIC, there were 1,814 banks that had assets fewer than $100 million; there were 3,522, banks with assets between $100 million and $1.0 billion.

One year earlier, on December 31, 2012, there were 1,954 banks with less than $100 million in assets and 3,607 banks that had assets between $100 million and $1.0 billion.

Before the recession, on December 31, 2007, these numbers were 3,066 and 3,705.

Thus, there are 2,252 fewer of the smallest banks since the end of 2007, 140 less than one year ago and 98 fewer of the larger category since 2007, 85 less than just a year ago.

The Wall Street Journal article also reports that 21 percent of the smallest banks had quarterly losses in the fourth quarter of 2014 and only 50 percent had earnings growth year-over-year in the fourth quarter of 2014.

The return on assets of these smallest banks was 0.63 percent in the fourth quarter and their return on equity was 5.43 percent.

There are several reasons why the performance is so dismal for these institutions and why many of the organizations are looking to sell... encouraged by the regulators.

First, there is the state of the economy. Economic growth is not robust and interest rates are historically low. Low demand is almost non-existent and the net interest margin that these institutions can earn is also historically low. The foundation for earnings is pathetic.

And there are substantial economies of scale in the lower range of bank assets. A former chairman of a bank with less than $100 million in assets that was sold in February is quoted as saying in the Wall Street Journal, "I've got the same cost whether I'm running a bank with $75 million in assets or $200 million."

Then there is the regulatory burden of new legislation, the Dodd-Frank financial reform act, which has hit the smaller banks disproportionately.

According to the Wall Street Journal article, "Regulators said they have tried to make it as easy as possible for community banks to adhere to the wave of new regulations." However, they recognize... as does the US Congress... that the burden can be substantial - sometimes, very substantial. But, the burden, nonetheless, is there.

Finally, and something that the Wall Street Journal doesn't address, is the added burden of new information technology. Banking is changing. It is affecting everyone. Although the changes are coming more slowly to the community banking sector, they are still coming.

And these innovations can have major impacts on the resource needs of the smaller banks. If you only have twenty employees of a bank and most of these are tellers or bookkeeping, adding specialists to deal with new information technology not only is difficult to achieve but it also can substantially skew pay scales in these organizations.

Furthermore, the changes are just going to keep coming and these smaller institutions find themselves farther and farther behind the norm.

The bottom line is that the banking industry in the United States is going to go through massive changes in the next five to 10 years. The country is just going to have to get used to having fewer and fewer banks and is going to have to get used to banking at the larger banking institutions.

The smaller banks, too, are becoming irrelevant. Federal Reserve statistics indicate that the largest 25 domestically chartered banks in the United States control 55 percent of all bank assets in the country. These statistics also show that foreign-related institutions control 18 percent of the assets. This leaves only 27 percent of the banking assets in the hands of the smaller banks.

In terms of the FDIC data, which contains only domestically chartered banks, commercial banks with less than $100 million in asset size control less than one percent of the banking assets in the country. Banks with between $100 million and $1.0 billion in assets control a little more than 7.5 percent of the banking assets of the country.

That is, the largest 540 commercial banks in the country, banks with $1.0 billion or more assets, which make up about 9.0 percent of the number of banks in the country, control almost 92 percent of the banking assets in the United States.

Small banks in this country are a legacy institution. The times they are a changin'.

It used to be that the United States, the President and the Congress demanded communities be supported by small banks. My grandfather was the president of a small, community bank in Missouri. He believed in unit banking... as did most of the country at that time.

For a good exposition of this setting is the new book by Charles Calomiris and Stephen Haber titled "Fragile By Design: The Political Origins of Banking Crises and Scarce Credit," published by Princeton University Press in 2014.

Now, it seems, the smaller banks have become too much of a burden - a liability even - and the President and the Congress and the regulatory system are moving in the opposite direction.

I am not saying that the movement should not be in this direction. In fact I am supportive of such a move. I am also supportive of the growth of "shadow banking" institutions.

However, people need to be aware that this change is occurring and it is being not being challenged by politicians in Washington, D. C., and elsewhere. The change is taking place and we need to make sure that the banking system we are evolving into is well thought out and well directed.

The regulators - the FDIC and the Comptroller of the Currency - have been doing their job over the past four years or so in making sure that the reduction in size of the banking system... the overseeing of the mergers and acquisitions that are going on... is done smoothly and without much fanfare. According to The Wall Street Journal, the regulators are seemingly succeeding in accomplishing this.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.