Will Consolidation Put an End to Community Banks?

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1 Ambassador Financial Group, inc. AMBASSADOR ALERT st Quarter One of the most discussed questions of the 2008 financial crisis and resulting recession is the following: will the new regulatory environment for financial institutions cause a wave of merger activity within the community bank sector? Within this article, I analyze the effects of Dodd-Frank on community banks of all size. I will assess the ongoing trends and offer advice on how to continue on a strategic path of independence. To accomplish this, I examine recent M&A transactions and mainstream thinking that small community banks (measured by total assets) will be unable to survive in this new world. Finally, I will present a group of small community banks that are outperforming the industry. This group of banks has shown great performance throughout this economic downturn. In studying this group, I have identified common characteristics that are indicative of their high performance. As soon as regulators and lawmakers began to think about fixing the banking system, community bankers felt the increasing burden of regulation. I could spend an entire newsletter on the topic of whether the bureaucrats are regulating the right entities. I do not recall community banks being the cause of the housing meltdown, being major players in the derivatives market or being forced to severely retrench from the lending market. But as is so often the case, Senator Dodd and Representative Frank used a broad-brush approach to writing financial reform. So even before Dodd-Frank was signed into law on July 21, 2010, market participants were trying to estimate the effect of the law on community banks. Industry groups, along with bankers, continue to lobby for better treatment as the law is translated into regulation. As the old saying goes, the devil is in the details, and as of today, no one knows exactly what the devil will look like. Universally, Dodd-Frank is believed to cause increased compliance costs and lower margins on certain products when fully implemented. The fact that the effects of Dodd-Frank continue to be fluid has not deterred market observers from predicting a great decrease in the number of financial institutions through consolidation (both government-assisted and unassisted transactions). Market observers have been very quick to suggest that smaller institutions will not be able to digest these greater costs within their business models. Every pundit seems to have a minimum asset size that will work in this new regulatory environment. The proper way to measure the effectiveness of any business model is by performance. Granted, economies of scale are important, but some of the best performing community banks are well below whatever the asset size of the day seems to be at the moment. I will demonstrate this point later in the discussion. Although Ambassador Financial Group is committed to the view that size is not the only determinant of survival, recent trends in the M&A market suggest that we are in the minority. I have analyzed announced, unassisted deals within the banking and thrift markets since the beginning of Within this period there have been 202 announced deals nationally. Segmented by the target s asset size, the largest percentage of targets is in the $100 million or less category. The full breakdown is displayed in the table on the next page (Figure 1.1). Certainly there are many more determinants that contribute to the decision to enter into an upstream affiliation, but the results of this simple analysis are striking. More than 75% of the transactions involve institutions with less than $500 million in total assets. It would seem that the decision makers at community banks are buying into the notion that the small banking business model has been negatively altered by the current regulatory environment. 1

2 Figure 1.1 Transactions Announced National Since January 1, 2010 Targets by Asset Size Number of Deals Percentage of Deals $100 million and less % Between $101 million and $200 million % Between $201 million and $300 million % Between $301 million and $400 million % Between $401 million and $500 million % Greater than $500 million % Total Number of Transactions % I suggest that community bankers measure the validity of their business model on performance and the expectations of their individual shareholder base and not on asset size. In an effort to validate this concept, we have examined recent performance (ROAA for the last 12 months) across the entire banking sector (Figure 1.2). Again, we have used total assets of $500 million as a dividing line. Figure 1.2 Performance for the Last Twelve Months Total Assets Number of Institutions Nationally Greater than 1.00% ROAA Greater than 0.80% ROAA $500 million and less 5,860 1, % 2, % More than $500 million 1, % % Segmented in this way, the data suggests that perhaps market observers are wrong about how smaller institutions are dinosaurs. A higher percentage of the smaller banks produced an ROAA of 0.80% or higher and 1% or higher compared to the larger banks. Critics of this analysis will suggest that the costs of complying with Dodd-Frank are not fully phased in for the sample period. We will concede on that point, but we will not abandon our belief in the resiliency of community banks. For well-run community banks, Dodd-Frank will eventually be added to a long list of industry changes that were going to cause the end of community banking. If performance and managing the expectations of shareholders are the key to remaining independent and missing this consolidation wave, we should examine both of these issues. First, we will discuss performance. As part of this analysis, we have selected a group of high-performing, small community banks from across the country. Please review the selected financial information for these institutions shown on the next page (Figure 1.3(a) and 1.3(b); see Figure 1.3(c) on page 4). 2

3 Figure 1.3(a) Financial Data for High-Performing Community Banks Company Name ROAE (%) ROAE (%) Net Income ($000) Net Interest Margin (FTE) (%) Efficiency Ratio (FTE) (%) Mifflinburg Bank & Trust Company , Fulton Savings Bank , Union Bank , Eastman National Bank of Newkirk , Byron Bank , Peoples State Bank of Plainview , Five Star Bank , Rock Springs National Bank , Steuben Trust Corporation , Peer Average , Figure 1.3(b) Financial Data for High-Performing Community Banks Company Name Total Assets ($000) Total Securities ($000) Total Lns & Leases ($000) Total Deposits ($000) Total Equity Cap ($000) Mifflinburg Bank & Trust Company 310,722 78, , ,406 31,381 Fulton Savings Bank 401,063 86, , ,804 63,726 Union Bank 453,245 24, , ,598 41,563 Eastman National Bank of Newkirk 195,851 36, , ,363 16,741 Byron Bank 216,379 54, , ,416 19,387 Peoples State Bank of Plainview 164,507 42, , ,902 15,860 Five Star Bank 399,339 14, , ,344 44,231 Rock Springs National Bank 336, , , ,388 27,759 Steuben Trust Corporation 340, , , ,318 35,328 Peer Average 309,712 65, , ,653 32,581 3

4 Figure 1.3(c) Financial Data for High-Performing Community Banks Company Name NPLs/Loans (%) NPAs Days Delinq/Assets (%) NCOs/ Avg Loans (%) Reserves/Loans (%) Reserves/NPAs (%) Mifflinburg Bank & Trust Company Fulton Savings Bank Union Bank Eastman National Bank of Newkirk Byron Bank Peoples State Bank of Plainview Five Star Bank Rock Springs National Bank Steuben Trust Corporation Peer Average I selected this group of institutions from all regions of the country, primarily using a statistical screening methodology. This grouping turned up three banks within our primary marketing area that we know well (Mifflinburg, Fulton and Steuben). Knowing the background of these banks aided us in isolating what characteristics and business practices set them apart from others. I then began to analyze the less familiar institutions to determine if they shared these highperforming traits. This analysis yielded the following short list of common characteristics: 1. High flying net interest margin; 2. Above average asset quality for their region; 3. Healthy levels of capital; 4. Reasonable efficiency ratios; and 5. A dominate market share that allows the institution to present itself as the community bank. I have always believed that successful community banks were able to gather and maintain a customer base that was willing to pay more for relationship banking. These nine banks exhibit this characteristic and it is evident by the above average net interest margin. The trick is to find customers that value the relationship enough to pay a premium for products that can be viewed as commodities. Being the community bank within your market is an essential part of this business practice. If you have to compete with other community banks for this type of customer, the ability to create a high net interest margin will be compromised. Asset quality mistakes can be painful on many fronts. Having a recurring need to provide for lending mistakes will create a drag on earnings and keep an institution from being a high performer. Recurring losses within the portfolio will hurt the capital position of any institution, and in today s environment, low capital levels can cause consolidation. Viewed regionally, our group of nine banks has demonstrated a superior lending culture. Asset quality is not an issue for any of them. I have saved our discussion of efficiency for the end, as it is the most likely category to be affected by Dodd-Frank. The use of the word reasonable to describe this category is intentional. The core customer of these banks will not stand for a no-frills approach to banking. Maintaining this profitable customer is paramount to the success of any community bank. Nonetheless, community banks must seek to be efficient in areas that do not affect customer service. Ignoring efficiency is not a successful long-term strategy for community banks. 4

5 When I discuss these issues with bankers, I often refer to the term shareholders expectations. Every shareholder has expectations for his or her investment. In prior years, common benchmark expectations for community banks were a 1.00% ROAA, double digit ROAE and a healthy dividend yield. Some investors expect that level of performance and consolidating transactions with high premium values paid to the seller s shareholders. Understanding these expectations has always been in the best interest of directors and executives of community banks. Now we believe that the very best community banks should be influencing these expectations through outstanding communication with shareholders. We recommend to all our clients that they communicate the dynamics of the changing banking environment to their shareholder base. If management believes that Dodd-Frank will change the institution s performance capacity, then this information must be communicated to the shareholders. If this is done in a forthright manner, investors will then be more able to determine if the institution s shares continue to be a good fit for their portfolio. Failing to communicate the dynamics of the current banking environment could lead to negative earnings surprises. There is no quicker way to be swept up in the wave of consolidation then to continue to report negative earnings surprises. With so much uncertainty surrounding them, community bankers face a difficult environment. Currently, no banker can be 100% certain of the costs and effects of the fully-implemented Dodd-Frank legislation. Business strategies implemented to counteract the costs of Dodd-Frank also have a degree of uncertainty. To counter these uncertainties, I view effective and timely communication with shareholders as particularly important at this time. Michael Rasmussen Managing Director, Investment Banking 5

6 Ambassador Financial Group, inc. THE AMBASSADOR TEAM: 1605 North Cedar Crest Blvd. Suite 508 Allentown, PA toll-free Joshua A. Albright Senior Vice President, Fixed Income Trading Allen Collins Managing Director, Chief Compliance Officer Ryan Epler Senior Vice President, Fixed Income Trading Heidi Geist Administrative Assistant James R. Gillen Managing Director, Business Development Timothy J. McDonald Chairman Robert J. Pachence, Jr. Managing Director Michael Rasmussen Managing Director, Investment Banking Matthew T. Resch, CFA Managing Director Eric R. Tesche Managing Director Mark B. Trinkle Senior Vice President, Fixed Income Trading John S. Walker, Ph.D., CFA Director of Research & Chief Economist The information presented is for informational purposes only. This is not an offer or solicitation to purchase or sell any security through Ambassador Financial Group, Inc., a current member of FINRA/SIPC. For more information contact us at Ambassador Financial Group, Inc.