Perilous times used to drive people to put money under the mattress. Today, smarter investors take their money to the bank. That creates opportunity for bankers, too, who have a chance to keep these new customers with compelling products and great service.

This is the niche of the community bank. And this is the community bank’s challenge for 2003.

The FDIC reported a solid growth in savings deposits of $50.9 billion in the first half of 2002 (the latest available data), which accompanied strong loan growth, especially among community banks. And net interest margins improved by 12.2% or 27 basis points at commercial banks during that time.

Banks have weathered the recent economic downturn with resiliency, even managing to sustain an earnings strength amid the turmoil of an uncertain stock market, corporate financial scandals and threat of war.

Despite increasing loan delinquencies, notably in commercial credits, the banking industry saw net income of commercial banks rise 17% to $23 billion in mid-2002 . Large banks took the brunt of the commercial credit deterioration; they look to benefit, though, through reduced lending to commercial borrowers, writing off problem loans and prioritizing fee income streams.

Meahwhile, community banks managed to maintain a 2.8% Q/Q loan growth and increased net interest margins. NIMs at small banks have traditionally been greater than at the largest banks. During the late 1990s, the NIM at small banks held steady, while it edged down at large banks, according to Fed research. In part, small banks maintained their NIM by increasing the share of their portfolios held as loans.

Banks deserve credit for their ability to weather the economic downturn and maintain profitability over the past couple of years. They achieved this through a little luck, but a lot of concentrated work: much improved risk management systems, income diversification, and a strengthening of their core businesses - taking deposits and making loans.
Such prudent business practices, aided by a low interest-rate environment, have helped banks to be vigorous competitors with other kinds of financial services providers and to do so in an economy that has remained softer much longer than most people expected. We also anticipate that the road to recovery still may have some trouble ahead. Banks already see a bit of interest margin squeeze in retail 3Q lending, due to greater competition for credit-worthy borrowers.

Maybe Smaller is Better

Small and mid-sized banks have consistently performed better than larger financial institutions in other categories as well. For example, commercial banks with assets under $1 billion receive a higher yield on earnings of more than 2% over banks with assets greater than $1 billion for the year ending June 30. Smaller and mid-sized banks also have a significantly higher efficiency ratio.

Small banks have been making money by earning better returns on assets and because of this, they have been able to compensate temporarily for a rising costs of funds. But that might be difficult to sustain. Banks still need to find less volatile ways to control their funding costs.

It is critical to our economy that community banks find lower cost, more stable funding. The reason is because we need community banks. Our economy needs community banks. They are key to the economic revitalization of our communities, through small business and farm loans, consumer and mortgage loans. Small businesses make up 99% of the country’s employers and create close to 75% of the net new jobs. And community banks are the primary source of funds for small businesses. In 2002, when commercial loan activity slowed, community banks continued to finance local loans. These banks are the financial shock absorbers for their customers and communities.

Community banks have their own role to play. Despite their competitive challenges, small banks grew more quickly than large banks between 1985-2001, and their profitability was sustained at high levels. However, as your readers know so well, they did this largely by increasing interest rates on deposit accounts to attract greater funding, (although this may be dropping off a bit today).

One interesting fact from a Federal Reserve economic paper earlier this year is that - the average size of large deposits at large banks in 2000 was $425,000, and at small banks, it was $229,000. However, during the 1990s, the average size declined at large banks and rose at about the rate of inflation at small banks.

Today, small banks are enjoying continued loan growth and increased core funding. However, an improved economy is likely to bring with it higher short-term interest rates and a narrowing of the yield curve spread. NIM will decline again.

Banks can survive on thinner margins, but they should have other options. They are too important to the economic revitalization of their communities, and of our country. We need all of our community banks to support an economic recovery and make it last.

In 2003

The facts suggest that 2003 is likely to be a challenging year. Even if the economy improves, we still face the lingering anxiety of the possibility of a terrorist attack, a protracted war in Iraq (and oil price shock), accounting rule changes, additional corporate scandals and an overreaction to these scandals by government.

At the same time, if there is one truism about a market economy, particularly the American free market economy, it is that powerful forces eventually push the pendulum back toward growth.

A key reason to maintain a focus on risk management, diversification and strong fundamentals is that the game will be won by those who are best positioned to compete when the economy truly picks up again. And community banks should be ready to demonstrate their value anew in good times as well as bad.

Eugene A. Ludwig, who served as Comptroller of the Currency from 1993-1998 and Vice Chairman of Bankers Trust/Deutche Bank, is currently Managing Partner of Promontory Financial Group in Washington, DC. He can be reached at contract@promontorgyfg.com