Community bankers are faced with a choice: sell, fold or exchange

Consolidation is a reality in banking, so it’s easy to ignore dire predictions that the next wave of mergers will flood the community banking sector.

But the case is becoming more and more compelling. There are many reasons, but one in particular is getting less attention than it deserves: The bank’s operating income has been declining for more than a decade.

“It’s an untold story. The industry’s dirty little secret,” said Anita Newcomb, a consultant in Columbia, Maryland. “The trends in operating income are unsettling. The question is why, as an industry, we are not talking about this.”

Operating income often takes a back seat to bankers’ concerns about rising cost of compliance or new restrictions on fee income. But at least one policymaker recently brought the issue to the fore.

“We are at a tipping point. There is a limit to the extent to which reductions in loan loss provisions can boost industry earnings,” FDIC President Sheila Bair said when releasing the results of the first quarter of the industry. “At some point, if banks want to keep increasing their profitability, they will have to increase their income.”

The trend is hitting the roughly 7,000 banks with less than $ 1 billion in assets the hardest. As a percentage of average assets, operating income at these banks declined to 4.45% at the end of 2010 from just under 6% in 1999. (See chart; recent rebound among the largest banks is due to business gains). Countless measures of the health of the industry and some of them, including credit quality, are improving. But nothing is more basic than operating income. It is net interest income plus non-interest income; So it shows how much banks are making on loans, products and services before deducting non-interest expenses and loan loss provisions.

“This is all about their core business model,” said Newcomb, who has worked with community banks for 25 years. “For me, it is the most important indicator of how well a company is doing.”

Banking tightening the vise is obvious: Fee income is killing itself at the same time that weak loan demand and low rates are crushing interest income.

At banks with assets of $ 100 million to $ 1 billion, net interest income as a percentage of average assets has been falling since 1995, when it was 4.3%. It fell below 3% in 2009 and, thanks to low interest rates, rose again to 3.5% at the end of 2010. But the trend is undeniably nasty.

Interest-free income isn’t prettier. It has been falling since 1999, when it reached 1.68%, and settled at 0.9% in 2010.

A crisis like this is never easy, but it comes at an especially difficult time for community banks. Compliance costs are increasing and regulators are demanding higher and higher levels of capital.

When interest rates rise, operating income will come under even more pressure as banks will be forced to pay more for deposits. It’s not hard to imagine investors fleeing and weak institutions going bankrupt or selling out.

The problems go beyond banking. The economy is growing slowly, the housing market is stagnant, unemployment is high, and government deficits are widening. To top it all, the image of the banking industry may be at an all-time low.

Put all of that together, and the anecdotes you hear about bankers who just want to throw it all away sound compelling.

“Several CEOs have told me that if they could see that they would get 5% of their money, say on CD, they would get out of the banking business,” said Frank Keating, president of the Association of American Bankers. “It’s just not worth it. The headaches, the heartache, the regulatory burden. They are being squeezed out.”

The squeeze isn’t exactly a novelty, either.

In 1990, banks with less than $ 100 million in assets made up 70% of the industry in number and owned 9.1% of its assets. By 2000, these banks represented 55% of the industry in number and owned only 3.5% of its assets. By 2010, it was down to 34% of the industry and just over 1% of its assets.

The image is not much brighter for the next level. The number of banks with $ 100 million to $ 1 billion in assets grew over the past 20 years, representing 57% of the industry at the end of 2010. But their share of industry assets dropped to 9.7% in 2010 from 22% in 1990.

The number of banks in the $ 1 billion to $ 10 billion range hasn’t changed much in the past two decades, but their share of assets has declined, to 11% in 2010 from 36% in 1990.

Of course, the industry is now dominated by banks with more than $ 10 billion in assets. In number, they represent just 2% of the industry, or 107 companies, but they control 78% of assets, up from just 33% in 1990.

These trends are expected to continue, and even accelerate, by 2020. Larger banks will own more assets, and the under $ 100 million crowd will continue to wither.

“Most bankers have not moved to think about what they have to do to survive. They are still squatting like a boxer,” said Charles B. Wendel, president of Financial Institutions Consulting in New York.

The trend in operating income “is a big problem,” Wendel said. “That operating income figure will continue to decline and decline until the bank becomes irrelevant or just sells.”

Earning income may not be easy, but the formula is not a mystery either: banks have to sell more to more people. They have to figure out which customers, products, lines of business, employees, and branches generate revenue and focus capital, training, technology, and pay in those areas.

None of this should be news to bankers.

Wendel recently unearthed a report his former firm wrote for clients 20 years ago. It was titled “The Art of Banking in a Period of Diminishing Income.”

“Pretty much everything in that report is critical, but most banks don’t do very well on fundamentals,” Wendel said. “Management does not have the experience, the self-confidence, or the courage to commit to taking the necessary action.”

Why is that?

“There are always objections [to change], and them [senior management] “Buckle,” Wendel said. “I know it sounds silly, but they do it. They just bend. They just don’t want to fight internal politics, internal pressures.”

In a good economy, banks can get ahead. Those days are gone. “The rising tide is gone,” Wendel said. “If the bankers think they don’t need to take action to change, they are dead ducks.”

Newcomb agrees.

“Very few banks have a real focus on monetizing customers,” he said. “That means having the products and services in place, and then training your people to sell those services. We are still suffering under an old model where commercial lenders focus on loans. That model just doesn’t work anymore.”

Newcomb predicts “a consolidation like we’ve never seen before.” By 2020, he expects the industry to total 4,900 institutions, or less than half of today.

Wendel expects an even more dramatic consolidation to leave only 3,000 institutions in operation within nine years.

Perhaps a banking industry half its current size is big enough. Maybe not.

But lawmakers and regulators should give that question some thought before it’s too late. And for any CEO who wants his bank to be among the survivors, now is the time to focus on the fundamentals.

Barb Rehm is American bankereditor in general. She welcomes your comments in her weekly column at [email protected]

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