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The Future of the Community Bank in an Era of Consolidation (Aaron Brooks Commentary)

4 min read

Last month, Arkansas Business Senior Editor George Waldon’s excellent cover story highlighted the considerable burdens imposed on banks that exceed the 2010 Dodd-Frank Act’s $10 billion asset threshold. 

But smaller banks across the country can attest that in today’s environment such challenges are not confined to midsize and large financial institutions. For the past several years, headwinds facing community banks have driven record levels of bank consolidation.

Since 2013, more than 700 U.S. banks have merged with or been acquired by another institution. During the same span, the number of FDIC-insured banks has declined from 7,083 to 6,270, with Arkansas experiencing a drop from 120 to 106 such banks. 

This consolidation has been heavily weighted toward smaller community banks, with more than 90 percent of acquired banks holding less than $1 billion in assets. The trend doesn’t appear to be slowing — analysts expect banking to remain an active deal sector in 2016 as community banks become even more attractive to their larger counterparts, and this week the CEO of the Consumer Bankers Association predicted that one in six banks nationwide will ultimately be forced to merge. 

Each of these acquisitions requires not only a buyer in search of growth opportunities, but a determination by the target that the time is right to sell. Why are community banks increasingly deciding that now is the time?

The Sale

The most commonly-cited cause of community bank struggles is Dodd-Frank, which marked its five-year anniversary last summer. Without delving into the merits of the law, it’s certainly true that legislation intended to address the perceived excesses of the country’s largest financial players has instead disproportionately raised compliance costs for the smallest ones. 

According to recent interviews with community banks and credit unions conducted by the Government Accountability Office, Dodd-Frank has caused increases in staff, training and time allocated to regulatory compliance, additional updates to compliance systems, and even a decline in newly-regulated business activities such as non-qualified mortgage loans. Small banks generally lack the size and scale of larger entities to absorb these costs, causing some to pursue acquisitions as the best means of improving operational efficiencies and spreading the burdens across a broader revenue base.

A closer look, though, suggests that attributing all small bank struggles to Dodd-Frank may be more convenient than accurate. After all, the number of banks in the U.S. steadily decreased during the two decades immediately preceding the law’s passage, suggesting that other systemic factors are at play. 

At a fundamental level, it’s become progressively difficult for banks under $1 billion in assets to stay competitive through organic growth alone.

Geographic and product deregulation, federal preemption and technological advances have allowed national and commercial banks to compete more directly in local communities, whittling away at community bank profits. Following the financial crisis, historically low interest rates have put pressure on bank margins. Disruptions in financial technology like marketplace lending, automated wealth management and e-payment platforms threaten to erode traditional banks’ historical share of these profitable products, and imbalanced loan portfolios can expose non-diversified lenders to industry-specific losses like those currently threatening energy-related assets.

Some management teams have taken a clear-eyed look at their future prospects as an independent entity in light of these factors and concluded that it’s time to pursue an exit strategy.

In addition to these competitive challenges, potential sellers are concluding that now is a good time to put themselves on the market. 

The above-discussed impact of size and scale on bank profitability is leading a host of midsize and regional institutions to explore growth through acquisition, giving sellers leverage to negotiate acceptable terms. Valuation multiples remain attractive and have been trending slightly upward despite interest rate uncertainty and market turmoil, with an average of 1.5x in 2015 and 1.3x in 2014. And more recently, with the Federal Reserve chilling large bank deal activity, activist investors have begun taking positions in underperforming community banks and pushing for a sale. 

Taken together, these dynamics make it difficult for bank leadership to exercise patience at the risk of being left behind and missing out on a desirable sale. 

The Cost

To be clear, the decline in community banks comes at a cost. These banks account for the largest share of small business and agricultural loans, a vital role in the health of the U.S. economy. Moreover, they hold particular importance in rural states like Arkansas where, as State Bank Commissioner Candace Franks has noted, local banks are often the primary or sole source of available lending. 

For this reason, as local banks continue to sell and the overall number of community banks remains in decline short-term, many maintain hope that through careful and innovative planning, cross-selling and customer integration, and a renewed focus on relationships, the community bank business model will evolve in ways that enable it to survive in an era of consolidation.  

Aaron Brooks is an attorney with Wright Lindsey & Jennings LLP, focusing primarily on mergers and acquisitions, corporate finance, securities compliance and general corporate matters. Email him at abrooks@wlj.com.

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