Financial Reform: One Year Later
What Is The Future For Community Banks?
Last fall, our lead article in this newsletter detailed the provisions of the Dodd-Frank Wall
Street Reform and Consumer Protection Act that would have the biggest impact on
community banks.
Since then, there has been a lot of discussion in the industry about what financial reform
will mean for community banks in the long run. While no one has a crystal ball to predict
exactly what the community banking landscape will look like years down the road, a bit of
clarity is starting to form in some areas.
Higher Capital Requirements = Lower ROE
What’s indisputable is, in the new post-reform banking world, financial regulators are
mandating that banks maintain higher levels of capital and equity. As equity is raised relative
to assets, return on equity (ROE) and, hence, one measure of profitability, will be reduced.
In a recent survey of investment bankers and financial industry consultants, it was
estimated that for community banks with less than $500 million in assets, return on assets
(ROA) would range from 50 to 85 basis points (bps) and ROE from 6 percent to 8 percent
by 2013. This level of return will be unacceptable for most community bank investors,
who generally look for returns of 11 percent to 14 percent.
It’s clear that going forward, one of the biggest challenges for community banks will be
raising capital in an environment where ROE may be considerably lower. For one thing,
Basel III imposes higher capital requirements on banks. Also, new Trust Preferred
offerings are no longer acceptable as regulatory capital.
In this environment, community banks have two choices: either generate more revenue
per each dollar of assets, or more profit per each dollar of revenue.
Summer 2011 Edition
©2011 Reynolds, Bone & Griesbeck PLC
What Is The Future For Community Banks? (continued)
Typically, banks have accomplished the former through fees. But Dodd-Frank limits how
much banks can charge merchants for debit card transactions (or interchange fees). Even
though banks with less than $10 billion are exempted from these limits, the reality is that
many community banks will be forced to lower their interchange fees in order to remain
competitive. It’s estimated that banks’ interchange fee income alone could be reduced by
up to 50 percent.
Meanwhile, new regulatory guidelines limit how much banks can charge customers for
insufficient funds overdrafts (or NSF charges). As a result, the two primary sources of
non-interest income for banks — interchange fees and NSF charges — will be significantly
reduced going forward.
And don’t forget about the repeal of Reg Q, which may result in community banks paying
interest on business deposits, and new limitations on accepting brokered deposits. The
bottom line: At the very time banks need to generate more net interest income, they will
be limited to generating less.
Incremental Interest Income
On the interest margin side, the best vehicles for community banks to generate more profit
per dollar of revenue have traditionally been residential mortgages, acquisition and
development and construction loans, and commercial real estate (CRE) loans. You don’t
need us to tell you what has happened to these types of lending the past few years. Also,
regulators have effectively capped CRE and construction loans at 300 percent of capital.
And on the expense side, financial reform places a greater regulatory burden on banks of
all sizes through new disclosure and reporting requirements, obligations and provisions.
These include new Home Mortgage Disclosure Act (HMDA) reporting obligations and
new rules designed to discourage discrimination based on gender, race or ethnicity.
While banks of all sizes are subject to these requirements, they will likely result in
disproportionately higher compliance and regulatory costs for community banks in
comparison to larger banks, which will benefit from economies of scale.
Finally, there is the big unknown of what will be the impact of the Consumer Financial
Protection Bureau (CFPB), the new federal agency tasked with protecting consumers’
financial interests. While the CFPB will not supersede regulators’ authority for
examination of banks with less than $10 billion in assets, the agency will have wide
discretion in deciding what constitutes “unfair, deceptive or abusive” business practices.
Summer 2011 Edition
©2011 Reynolds, Bone & Griesbeck PLC
What Is The Future For Community Banks? (continued)
Strategies for Survival
To succeed in the challenging environment that lies ahead, community banks will need to
develop a comprehensive strategic plan. Here are a few survival strategies to consider:
•
•
•
•
•
Identify alternative sources of loans and develop alternative sources of fee income.
Enhance collection of existing fees.
Build core deposits.
Develop a strategy for dealing with the competitive implications of Reg Q.
Employ risk-based pricing.
Survey Says… Banking industry experts Walt Moeling and Jim McAlpin recently conducted an informal
survey asking investment bankers and industry consultants what they foresee as likely
developments in the banking industry over the next few years. Here are summaries of a
few responses:
• The ideal community bank will either have a dominant market share in a rural slow
growth market or, if located in an urban market, it will have enough scale and product
offering to compete for deposits with larger banks.
• The regulatory costs of operating a bank have increased such that, in all but rural
markets, it will be difficult for banks with less than $500 million in assets to produce
adequate long-term returns.
• One billion dollars in asset size will not be considered a large bank. In fact, the
demands for 11 percent to 14 percent ROE will create a $1 billion minimum size
threshold for surviving banks.
• Deposit mix will be the most important key to achieving consistent profitability.
Maintaining core deposits and identifying consistent and reliable low-cost funding will
be crucial.
• There will be significant consolidation among community banks, with as many as onequarter of the roughly 6,000 community banks that exist today lost due to mergers,
acquisitions or failure.
Source: Bryan Cave LLP
Summer 2011 Edition
©2011 Reynolds, Bone & Griesbeck PLC