Monday, April 15, 2013

Are Some Banks Too Small to Survive?

With increasing regulatory capital requirements, declining interest margins, a greater need for investment in innovation and new competition, there are many in the industry who believe that smaller banks may have limited opportunity for growth in the future. 

These pressures may lead to an acceleration of consolidation in the banking industry that impacts both small and mid-tier banks and results in a significantly reduced number of institutions in the future.

While attending both the BAI Payments Connect and CBA Live conferences in Phoenix last month, discussions often revolved around the heavy financial and organizational impact of new capital requirements and of regulatory compliance being faced by institutions of all sizes. It was also clear that the investment in advanced technology and the pace of innovation was creating a distinction between the 'haves' and the 'have nots'. While there were some exceptions, this line of demarcation appeared to be defined by the size of organization.

The question I asked several industry thought leaders over the past couple weeks is whether smaller banks are in a position to survive given the massive industry changes on the horizon. While their responses varied regarding the chances of survival for today's community bank (and smaller credit union), there was unanimity in their belief that smaller institutions must quickly adjust to the 'new reality' of increased capital requirements and regulatory pressures, a greater focus on revenue, and a need to innovate for an enhanced customer experience.

"The thing that keeps me up at night is that we will likely see an industry contraction in the next decade like we never experienced", states Bradley Leimer, vice president of the $3.2 billion asset Mechanics Bank in California. We are moving from over 14,000 financial institutions today to less than 5,000 in the next 10 years (maybe sooner). This is due to the changing nature of consumer behavior with the introduction of mobile and social and technological innovation, but also due to systematic changes to the banking model itself."

Also supporting my informal findings, Emily McCormick, director of research and writer for Bank Director, interviewed the risk officer of an $8 billion bank holding company for Bank Director's 2013 Risk Practices Survey. He told her that, while he found a lot of positives in the regulations coming out of Washington, this could be a challenge for smaller banks that lack the resources and staffing to keep up.

McCormick also believes there's a technology challenge, "Internally, smaller banks need the right resources to do things like manage risk, but they also need the resources to compete. While smaller banks have the significant benefit of connections within their local business communities - giving these banks a potential advantage in business lending - customer expectations for services like mobile and online banking will continue to rise."

Increased Capital Pressures

According to an Invictus Consulting Group report entitled, Buyers and Bleeders, more than half of today's institutions will need to participate in some type of M&A activity based on new capital requirements alone. This includes as many as 2,000 banks that should sell due a lack of financial return and/or a lack of capital. In addition, the report believes that as many as 3,500 institutions have enough capital, yet lack loan demand and therefore need to deploy their capital to acquire banks that will grow their business. Unfortunately, even some of these firms with capital may not have enough to spend to grow to the level to be competitive.

An interview of Adam Mustafa, managing director of Invictus, was done by Bank Director Magazine to discuss the research report findings. 

Impact of Increased Compliance

According to an October 2011 research report developed by Aite Group entitled, Reducing Banks' Compliance Toll, the annual cost of compliance for banks well exceeds $1B. Unfortunately, many of these costs (personnel, software, etc.) are 'fixed' infrastructure costs which place a heavier relative burden on smaller organizations who still must comply with many of the same regulations.

According to the Aite report, however, many institutions have failed to take advantage of technology and process improvement steps that could reduce redundancy and paper intensive processes that are a major contributor to these costs. Aite (and many other consultancies noted in the report), believe that the end game is an 'electronified' organization that can eliminate paper and enable real time information management.

Unfortunately, this automation of processes requires a substantial investment that may bring long term benefits, but is not affordable to many smaller institutions today given other priorities.

The Innovation and Distribution Imperative

While we could discuss for days whether or not the improvement of branch-based, web, online and mobile interactions should be considered 'innovation', there is no disputing the fact that the typical banking customer is expecting more services, delivered through more channels than ever before. As I experienced in person at the two conferences in Phoenix, the investment in innovation is both required and substantial.

According to Leimer, "If community based institutions are going to relevant going forward, they need to be much more agile and much more focused on partnerships with technology providers and other similar shaped financial institutions. We must work together to partner and innovate to deliver community based services in a hybrid model - centralizing resources, sharing innovations, riding on non-traditonal service frameworks - the type of cooperation these institutions haven't historically embraced." 

In addition, as consumers embrace the smartphone and do more of their banking online and through mobile devices, additional negative dynamics occur. According to Sherief Meleis, partner at financial consultancy Novantas, the reduced importance of local branching means that banks are moving from being primarily local retailers (where the average community bank could simply out-local the big banks), to product/marketing organizations where there are indeed economies of scale. 

"In an environment where the branch importance is diminishing from a transaction perspective, it’s difficult for smaller banks to afford the required fixed cost (just like with regulation and compliance). Our analysis suggests that super-regionals and national banks have substantially higher returns to branch network position, due to their ability to invest in product innovation and brand marketing."

This position was shared in a recent American Banker article entitled, "Why Regional Banks Are The Right Size Right Now" where the case was made that regional banks benefit from the scale to absorb compliance and regulatory costs better than their smaller brethren, yet are nimble enough to develop new technologies that can improve service delivery and efficiencies. This was evident in their chart showing the ROE for different sized organizations.

Power of Shared Services

As shown above, critical mass is a "sine qua non" for success in today's highly competitive market place. One of the impediments to small size is that it gets difficult to embrace new technologies and improve your operating margin as investments in technology do not give the same payback as it would for the larger banks. Therefore small banks need to take advantage of some one else's strength and critical mass and deal with a service partners and business process outsourcers that are able to improve efficiency ratios.

According to Nicole Sturgill, research director for retail banking and cards for CEB TowerGroup, "Small banks have the opportunity to take advantage of single supplier discounts (i.e. using one solution for branch sales and service, online banking, mobile banking, etc.). In addition, there are a number of solutions that cater to the community bank and credit union markets, which offer lower pricing because they are selling to thousands of institutions (i.e. mobile RDC and PFM)." She adds, "While these solutions may not offer all of the wiz bang functionality of a large bank solution, the increased focus on personal service that a smaller bank provides may give them parity if not an edge on the larger banks."

While there are some very good banks of all sizes, the efficiency ratios get better as we have some critical mass, according to Sankar Krishnan, global banking engagement head for business process outsourcing leader, Sutherland Global. "Companies that provide operations and technology services to banks and are able to improve the operating metrics have a great role to work with the smaller institutions (Community, Regional etc). They can provide industry best-in-class knowledge and help support their efforts to get better on efficiency ratios and operating margins."

Some Small Banks May Survive . . . If They Have a Plan

There is very little doubt that, given the economic environment and the paucity of available capital for smaller banks, the number of banks will certainly decline over the next several years. This decline may simply be a continuation of recent history – or the consolidation of the banking industry could accelerate. While most of the advisors I contacted agreed that small banks must take an aggressive stance to increasing sales and reducing costs to survive, they also believed that some smaller institutions may be positioned to succeed in the future. 

Mary Beth Sullivan, managing partner of Capital Performance Group, thinks that earnings pressures for smaller banks will be even more significant in 2013 than in the past but states that many banks may not simply succumb to the pressures to consolidate. "Smaller banks are sometimes odd characters . . . many will continue to hold onto their independence as long as possible."

Serge Milman from Optirate warns that deploying technology and/or introducing products and services without the benefit of a comprehensive business strategy is an effort that is likely to disappoint.  "Just look at institutions that have deployed these tools and most will show little or no improvement in profitable customer growth, increased wallet-share and certainly, not higher ROE.  This approach is analogous to attempting a cross-country drive without a map (or GPS) --- no one would try this, yet Bankers do exactly this every day of the week!"

Milman continues by saying, "The journey to growth, profitability and customer loyalty must begin with a sound strategy that is supported with a measurable and implementable operational plan.  Community Banks can succeed, but to do this, they must embrace the reality that the world has changed and they must willing to adapt."

"There's only one strategy that makes sense for smaller banks: get more sophisticated about analyzing customer feedback and leverage the voice of the customer to prioritize which initiatives to pursue," stated Steven Ramirez, CEO of communications consulting firm Beyond the Arc in an email interview.
"Smaller banks have the potential to gather deeper insights about their customers, but few of them do. Since small banks can't invest in everything, they need to focus on what really matters in their local market."

Brad Leimer probably summed up the conundrum of smaller banks best when he said, "There is space for community minded institutions in the financial marketplace of the future - but they will look and act much differently than today - simply because the banking model has seen a significant shift."

Additional Resources

Buyers and Bleeders: Invictus Group (March 2013)

Bank Director 2013 Risk Practices Survey: Bank Director (March 2013)

Reducing Banks' Compliance Toll: Aite Group (October 2011)

Why Regional Banks Are The Right Size Right Now: American Banker (April 2013)

Subscribe to Bank Marketing Strategy Via Email


  1. Excellent Practical discussion on why the "Small is Beautiful" a great concept by Economist E.F. Schumacher may not directly apply to Banks that have to compete in the marketplace and what alternatives are availablel to help them compete and win.

  2. I agree with the assumptions in this article; however, I believe most of the consolidation will be with credit unions as more than half have less than $50,000,000 in assets. In fact, according to the NCUA, the average ROA for credit unions with less than $10,000,000 (and there are a lot of them) is -0.01.

    Both banks and credit unions alike are "bombarded" by the onslaught of new regulations, but the inflexible and fixed cost base of small credit unions will not allow them to adapt.

  3. Accurate and timely Jim, the pace of technological growth, increasing risks and decreasing margins are putting a lot of pressure on the smaller banks. That's one of the reasons we are redesigning our product to better serve their needs. Frankly, it will become innovate or die in the coming years.

  4. Great post Jim, and I agree with the comments of Brad, Serge and Steve. My partners and I have been having a lot of conversation about this very topic around our firm lately, and our collective experience is that despite certain scale advantages, superior execution around a specific strategy is even more important. Those FIs that want to stay independent will have to pick the segments and strategies that they can excel, and focus on execution over being all things to all people and and simply relating growth to geographical expansion.