EconSouth (Second Quarter 2005)

Putting a Name With a Face:
Community Banks Count on Customer Service

The advent of megabanks during the past decade or so has made many policymakers and industry pundits fear that smaller, community banks will soon go the way of the dinosaur. But community banks appear to be thriving by providing personalized services that meet their customers’ unique needs.

Rumors of the death of community banks have been greatly exaggerated, to paraphrase Mark Twain. Community banks are alive and well in 2005 despite prognostications in the 1990s that the end was in sight. Back in 1996 when Federal Reserve Chairman Alan Greenspan was asked if he agreed with those who were predicting an end for community banks, he replied with candor that the predictors were “just plain wrong.” Turns out, he was right.

Perhaps to the average retail bank consumer in a large city, a bank is a bank is a bank. But to bankers and policymakers, there are big differences among banks, and community banks fulfill an important need even today.

Community banking means just that: Small banks operating in community environments, mostly owned and run by people who live in the community and supported by customers who like doing business with their neighbors and friends. The Federal Deposit Insurance Corp. (FDIC) defines a community bank as a depository institution with assets of less than $1 billion.

By many accounts, though, it seems the big banks are trying to muscle in on community bank territory by offering longer hours, improving customer-service training, and trying to make big seem small and personal in the eyes of the consumer. But there are distinct advantages to both large and small banks.

Big banks, which have merged and merged again into colossal financial institutions—termed large banking organizations, or LBOs, by regulators—excel at transactional banking. These large banks move people in and out of their lobbies quickly, provide convenient services like online bill paying and ubiquitous automated teller machines (ATMs), and make decisions by the book using standardized formulas. For the urban multitasker, these one-on-every-corner entities hit just the right note of anonymity and streamlined convenience. According to a spokesman for the Independent Community Bankers of America (ICBA), what the big banks usually lack and the community banks excel at, however, are the intangibles: flexibility, intuition, empowerment, history, and the ability—indeed, the charge—to employ what researchers call “soft” information (loosely defined as third-party personal opinions) in their decision-making process.

In contrast to large banks, community banks have less geographically diverse retail outlets, less marketing, less product branding, and perhaps less technology on their side. What these banks do have is the ability to cultivate personal relationships, those one-on-one, almost neighborly exchanges that recall earlier times. Even in the 21st century, many community banks continue to find that their customers choose human interaction over faceless technology, and the banks are taking advantage of that preference. According to Joe Brannen, president of the Georgia Bankers Association (GBA), “People bank with people, not institutions, especially on the commercial side of the bank. Bank mergers have created opportunities for bankers to move to other, smaller institutions, and their customers often follow them.”

Action and reaction
For the better part of the last two decades, the media, community leaders, and policymakers, the Fed among them, worried about community banks’ fate as more and more bank mergers created so-called megabanks. The thinking was that if the big banks squeezed out the little banks, either by buying them up or by enticing their customers with strong brands and high-profile marketing programs, communities would suffer, particularly small businesses that were often in a better position to obtain loans from community lenders.

Despite these concerns, community banks seem to be thriving in the Southeast and throughout the country. In many cases these banks fill the gap left by the large national retail banks when they merge and consolidate branches, centralize lending authority, and homogenize services. In a recent speech, Federal Reserve Bank of Kansas City president Tom Hoenig noted that “community banks have found a unique and essential role in picking up business that doesn’t quite fit the parameters under which other institutions operate.”

In research on the community bank experience (Atlanta Fed Economic Review, first quarter 2005), Scott Hein, a visiting scholar at the Federal Reserve Bank of Atlanta and professor at Texas Tech University; Timothy Koch, chair of banking at the University of South Carolina; and Scott MacDonald, adjunct professor at Southern Methodist University and president of the SW Graduate School of Banking, note that many factors and circumstances seem to argue against the long-term success of community banks. They point to an excessive concentration of risk in lending, competitive pressures from deregulation and new technologies, and limitations on market power, brand recognition, and technological investment as leading drawbacks among community banks.

On the flip side, these researchers argue, are the reasons that community banks are flourishing. What they have been doing right, community banks continue to do in greater measure to take advantage of their unique position in their communities. According to Hein, Koch, and MacDonald, managers at community banks process information differently than their counterparts at the big banks. Community banks rely more on long-term customer relationships, which provide experience that bank managers can use to assess risk in lending situations. Also, with more local ownership, community banks can delegate more decision-making authority to the branch and individual employee level.

Credit where credit is due
As big banks have grown, the efficiencies gained in their operations appear to have become greater. These efficiencies, gained by providing standardized services to hundreds of thousands of customers, make it difficult for community banks to compete for noninterest income, which is an important source of future earnings for banks. Noninterest income comes from fees on checking accounts and service fees on loans. Large banks generate much of their fee income from cash-management and wealth-management services while smaller banks rely heavily on fees for deposit services.

What drives customers to community banks is the nonstandard services they typically offer, particularly in the credit arena. Even though these services often come at a premium, the customer will pony up for the cost if they meet his special needs. Indeed, the community bank will often provide a value-added component to nonstandard services. For example, if a community bank lender gathers soft information to make her lending decision regarding a small business, she may also provide additional guidance and counsel to the customer in the form of business planning, accounting, and tax planning expertise, according to Hein, Koch, and MacDonald. In other words, the banker’s intervention provides real, human value to the process whereas a big bank probably depends on simple, quantitative credit scoring to arrive at the approval or denial decision.

According to banking industry leaders like Rusty Cloutier (see Q&A), president and CEO of MidSouth Bancorp and MidSouth Bank in Lafayette, La., and past chairman of the ICBA, the community bank’s strength resides with its ability to cultivate customer relationships, to amass knowledge about customers and their businesses, and to tailor services to particular customers’ needs as opposed to providing a wide array of services that customers may or may not care about. According to Hoenig, good relationship lending also entails closely monitoring a borrower after a loan is made and then continuing to meet the needs of the small business as the operation becomes successful.

Community banks are measuring up
In a 2003 study by the Kansas City Fed, community banks accounted for one-third of the small business lending done by banks nationally. This share is much larger than the share of all bank deposits held by community banks.

“The community bank’s role in small business lending is increasingly important today as large banks push back from individual communities, concentrating their lending authority away from the borrower,” said James Beall, chief executive officer of Farmers & Merchants Bank in Centre, Ala., and a member of the Atlanta Fed’s board of directors. “Because small business loans often fall into the category of creative lending, the community banker has more tools at his disposal to make these loans, such as special insights into the future of the community and the individual borrower’s connections within the community.”

And since, according to the U.S. Small Business Administration, small businesses—those with fewer than 500 employees—represented 99.7 percent of all employers and employed half of all private sector employees in 2004, small business lending represents a significant piece of the overall economy. Community banks thus can be an incubator for small business growth.

Banking on relationships: Exploiting the niche
For community banks, the strategic focus is on relationship banking. It’s an important niche, but different community banks have different emphases. The goal of some community banks may be relationship deposit gathering while others may target relationship lending. Both of these strategies have proved viable for banks, but it is important to note the factors driving these two different business objectives.

Photo by Flip Chalfant
Community banking means just that: Small banks operating in community environments, mostly owned and run by people who live in the community and supported by customers who like doing business with their neighbors and friends.

A community bank that is interested in building franchise value via deposits is often family-owned and managed, note Hein, Koch, and MacDonald. This kind of bank is often somewhat risk averse, fearing the loss of a steady stream of earnings. Other deposit-driven community banks, the authors note, may operate in rural areas where growth and business expansion are limited, thus constraining small business lending opportunities.

Loan-driven community banks, on the other hand, generally operate in high-growth markets such as fast-track suburbs of growing metropolitan areas. Since loans typically afford the bank the highest yields before taxes and expenses, according to Hein, Koch, and MacDonald, bank managers can increase profits faster by increasing credit exposure. These kinds of banks, the researchers observe, rely proportionately more on purchased liabilities to fund loan growth. Because they have access to relatively low-cost Federal Home Loan Bank advances, these banks are not limited to lending at the pace of core deposit growth. Loan-driven community banks further differentiate themselves from each other by the types of lending they emphasize: small businesses, agricultural borrowers, or mortgage customers.

The easy availability of brokered deposits and Internet deposits is allowing these loan-driven community banks to grow rapidly, said Ronald Zimmerman, the vice president overseeing the community banking section of the Atlanta Fed’s bank supervision and regulation division. This rapid growth is causing regulators some concern about whether these banks’ infrastructure is keeping pace. Another reason for concern, Zimmerman notes, is that some of these banks have been moving into markets outside the service area they are most familiar with and into new products where they may not fully understand the risks.

Constraints on community bank growth
Despite their viability on many fronts, community banks face some unique constraints to growth. More and more community banks find themselves weighed down by what community banking trade associations have described as regulations that disproportionately burden community banks, according to a 2005 press release from the ICBA. Over the past 20 years the passage of the (Riegel-Neal) Interstate Banking and Branching Efficiency Act and the (Gramm-Leach-Bliley) Financial Services Modernization Act as well as the newer demands of corporate governance have put added relative strains on community banks, the ICBA contends. Complying with these regulations requires the allocation of human resources that community banks have a more difficult time providing.

The GBA’s Brannen notes that “the enormous and growing regulatory burden is weighing heavily on the minds of every community banker. Safety and soundness regulations are institutionalized within the banks’ compliance structures, but the new and growing federal requirements for issues such as governance, anti-money laundering, and anti-terrorist activity are [taxing].”

Unlike large banks, which derive significant benefits from noninterest income such as fees on volume transactions, community banks face a much harder time generating this income because they are not transaction based and they don’t reap the rewards of scale efficiencies, according to the ICBA. And some observers, like Hoenig, have said that community bankers will have to find a way to develop new sources for noninterest income in order to enhance their bottom lines.

Community banks, while generally less focused on technology, are also constrained by the high cost of technology, but they must, like all banks, allocate significant resources to ensuring the security of computer-based records and information.

In addition, community banks may be constrained by the limited availability of management talent and expertise, particularly in small, rural communities, notes Zimmerman. In these areas, community banks “often have to ‘pay up’ to get someone who will be willing to move there and are very vulnerable to staff turnover,” he said.

Start-ups stay on course
More than 1,250 new community banks have been established since 1992, according to FDIC data. This start-up activity makes a compelling argument for the continued presence of community banks in today’s banking landscape. Many of the de novo banks have been established in markets where former community banks were acquired by large and geographically distant banks.

At these de novo banks, “the new management often comes from a merged bank; the president of the sold bank gets a group together and becomes the chairman of the new bank,” said Zimmerman. “These ‘displaced’ bankers frequently bring a book of business and long-standing relationships with them to the new bank.”

Brannen points out that five to 10 new banks traditionally open each year in Georgia. Activity in 2005, he said, could far exceed that number: 18 different organizing groups have either filed charter applications or will do so soon. Where community banks locate and do well varies from state to state. “While community banks are performing well all over Georgia, the rapid growth is clearly in the metropolitan areas, along the coast, and in the mountains,” said Brannen.

Investor interest in de novos appears to be extremely high, according to Zimmerman. “Not only are many de novos forming, but the starting capitalizations also seem to be getting larger and larger. The organizing groups have little problem raising $10 million, $15 million, and even $20 million in capital,” he said. But having this much capital is in some respects troubling, he notes. Regulators worry that high investor expectations will prompt management to take too much risk and that the higher capital amount will create a larger lending limit on individual loans.

While all but the smallest asset category of community banks have been successfully growing in recent years, according to a 2004 FDIC study, their deposit share as a percent of total bank deposits has declined since 1985. But the study shows that the earnings performance of community banks from 1992 to 2002 was steady and in fact comparable to that of the very largest banks.

Raising the bar
Some analysts have observed that large banks are raising the bar on service and delivery hours, and their retail strategy is paying off handsomely for them in terms of attracting and keeping customers, especially on the retail side. Large banks are also spending significant dollars in training their employees to be more customer oriented, and this strategy is evidently working well, judging from recent consumer satisfaction surveys. The University of Michigan Business School’s 2005 American Customer Satisfaction Index, for example, gave Wachovia Bank the highest index score (78 on a 100 point scale). This rating comes two years after the bank completed its largest merger ever, with First Union, in 2003.

Some community banks, especially in metropolitan areas, are matching those delivery hours and training, but many do not need to because they have performed this way all along.

Despite concerns about their stamina, community banks continue to thrive and provide that personal touch that many customers still crave.

This article was written by Lynne Anservitz, editorial director of EconSouth.

Counterpoint: Big Banks Beckon with Branches and Other Benefits

In contrast to community banks, large banks in the Southeast—those with assets over $1 billion—have gone through the same rounds of mergers as banks across the country. Some banks once headquartered in Georgia and Florida have merged and now have their home offices in North Carolina while large banks like SunTrust, AmSouth, and Regions Bank are still based in the Sixth Federal Reserve District.

With all these mergers, there are several potential benefits for customers: more branch offices, better online banking services, and back-room efficiencies that may help hold down the cost of services. For shareholders, big banks generally are proving to be worthwhile investments as well.

Some reports show that large banks are perfecting the art of online banking, and customers are jumping on board in record numbers. A 2005 study by comScore Networks, a research firm specializing in the measurement and analysis of consumer behavior and attitudes, reports that 53 percent of online banking customers at the nation’s top banks use online servicing capabilities, including transferring money, setting up recurring payments, and reordering checks.

The study of 1,500 U.S. consumers found that customers using e-servicing are more loyal to their banks and that e-servicing adoption and usage tends to correlate with customer satisfaction. Of the top consumer banks, Bank of America/Fleet and Wachovia, both based in the Southeast (although not in the Sixth Federal Reserve District) ranked first and second, respectively, on an index rating.

Enviable investor returns
For shareholders, big banks currently provide significant quarterly profits. The Washington Post recently reported that first quarter 2005 net profits were up 30 percent at Wachovia, 36 percent at SunTrust, and 75 percent at Bank of America compared to the same period a year ago. Additionally, AmSouth Bank and Compass Bank, based in Alabama, both reported record first quarter 2005 earnings.

The article credits consolidation and new technology, both of which have allowed banks to cut a significant chunk out of their operating costs, with the increase in shareholder value. The scale efficiencies of combined back offices and branch networks look good on paper. In addition, the mergers provide more ATMs, automatic deposits, online bill paying, and computerized loan approvals that make it possible to shrink payrolls even as business grows.

Convenience versus fees
While research has yet to determine the consumer benefits in all these mergers, a few studies as well as anecdotal evidence suggest that although consolidation hasn’t yet lowered the price of services, it has improved convenience and the breadth of banking services. But according to a 2005 study by Accenture, a management consulting firm, 54 percent of 1,000 U.S. consumers surveyed don’t believe they benefit from retail mergers. The study reports that 42 percent believe mergers result in higher prices, compared with 24 percent who believe mergers lower prices. Further, 32 percent said mergers result in worse customer service, compared with 23 percent who say mergers improve customer service.

The big banks are working hard to respond to both customers and competition on the convenience front. Charlotte, N.C.–based Wachovia recently announced a plan to improve customer convenience by keeping select branches open later on weekdays and Saturdays. The bank will test the program initially in the Washington, D.C., area, with rollout to other major markets later in the year. Undoubtedly, other big banks will match this effort, and customers should be the ultimate beneficiaries.

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