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The pace of consolidation in banking seems poised to accelerate, and for the same reasons that we see so many fewer small grocery stores than we did 30 years ago.
Scale really does matter, in grocery retailing and in banking. Fixed costs with little revenue to spread them over are painful and, thanks to post-Great Recession banking regulations kicking in, getting more painful for smaller banks.
It's hard to see how credit needs will be better met with fewer community banks, but consolidation has marked many industries that then kept serving customers well.
What makes this coming round of consolidation disappointing, however, is the key role that apparently will be played by the expense of complying with government regulations.
The total number of banks in the state has already been on a long decline, including some 21 bank casualties during and after the Great Recession. At the end of 2007 there were 420 banks in the state, and as of June that was down to 364.
Bank analyst Ben Crabtree, senior adviser to Oak Ridge Financial, said he expects the contraction to continue, with more market-based mergers as the number of bank failures likely declines.
The selling he expects is certainly not because there are lofty prices to be had for sellers. Crabtree said "the going rate for Midwestern bank mergers is book [value] to book and a quarter," vs. greater than two times book value common in the 1990s.
So why sell? His simple explanation is that the economic model increasingly favors bigger banks.
As Crabtree looked at the data from the Federal Deposit Insurance Corp., he noted that larger banks generate more noninterest revenue as a percentage of assets than do smaller banks, and also have lower noninterest expense.
Another way to look at that is a commonly used banking yardstick called the efficiency ratio. Banks of between $1 billion and $10 billion in assets spent less than 60 cents for each dollar of revenue on operating expenses as of midyear, and banks between $100 million and $1 billion spent 70 cents for each dollar of revenue.
The most recent trend lines show a widening gap in efficiency and returns on equity between those two sets of banks.
Crabtree said he doesn't see an easy way for community banks to close the profitability gap, not with the additional relative expense of regulatory compliance.
"We are only at the front end of this whole [implementation] process" of recent reforms, said Edward J. Drenttel, an attorney and shareholder at the Minneapolis law firm Winthrop & Weinstine who represents banks. "As the cost of compliance becomes more significant, it inordinately hits the profitability of small banks.
"It's not just talk, it's real. And it's only going to get worse."
Bankers may talk about regulations the way farmers complain about the weather, but even Ron Feldman, the Federal Reserve Bank of Minneapolis' senior vice president for supervision, regulation and credit, explained that regulatory compliance may be a factor in bank consolidation.
It takes both more effort to comply with regular oversight, he said, as some past informal practices in a small bank needed to change, and real work to address newer rules such as those around consumer lending.
"Basically, you need to have somebody in the bank who's really knowledgeable about those rules if you want to comply with them," Feldman said.
The median number of full-time-equivalent employees in banks of less than $50 million in assets is about 11, Feldman said, "so everybody is wearing a lot of hats.
"The regulatory hat is becoming bigger and bigger so that means somebody is going to be spending a lot of time on something that is not generating revenue," he said. "Whether this is hugely more costly or just slightly more costly, that's hard to pin down precisely.
"But it's more costly. It's fixed, to make one loan you have to comply."
Crabtree said he just spoke with executives at a Twin Cities community bank with less than $500 million in assets that works only with business borrowers. In the past it would make the home mortgage loan for its business clients, for a business owner or a family member.
To comply with new mortgage lending rules, Crabtree said, this bank's leadership concluded that the bank will need to hire three full-time people, including a licensed attorney, all to support a non-core courtesy service for its best clients.
The fixed cost of regulatory compliance is even worse for start-ups than small established banks, Crabtree said, part of the reason he doesn't expect to see many start-ups anytime soon. In the middle of the last decade nationally there were about 170 newly chartered banks every year, and that fell to five in 2010 and exactly zero last year.
Each bank has its own set of competitive circumstances, but based upon conversations this past week it appears community bankers can choose among several unattractive options to deal with the cost problem.
One is to simply absorb the additional regulatory compliance costs and make less of a return on capital. Another, Feldman said, is to narrow the bank's activities to avoid some of these costs, such as totally steering clear of consumer loans.
The latter is an unhappy prospect for a lot of bankers, Feldman said, and he uses the example of a small community bank that might get a request for a seven-year, interest-only loan secured by a mobile home.
It's the kind of oddball request no big bank mortgage loan officer would touch, but in the past the community banker may have done it as a service to her local community. Perhaps not anymore.
Another option, of course, is just selling the bank, as Crabtree predicts we will see more often.
Valuations may be disappointing for those bank owners who had been planning to sail into retirement after selling at a big premium, but, he said, "it's kind of like the old investor's prayer:"
"'Lord, get me out even, and I will never do it again.'"
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