Fintech Is Friend and Foe to Community Banks

 | May 25, 2016 | 4:00 PM EDT
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I spent Monday and Tuesday in Dallas at the Bank Director's Growing The Bank conference, and you can read some of my coverage from the event here.

It was fascinating to see the insider's view of what banks are doing to try and grow assets and earnings in the current, difficult operating environment. Fintech was the favored topic of the day, as banks look to partner with, and even acquire, some of the leading edge technology companies that are providing financial services.

Although I heard some great ideas about using Fintech to add fee services like wealth management and financial planning, speed up the lending process and expand mobile offerings, I am not sure how much of a fix they will be. The regulators are just now getting around to focusing on Fintech and when they are done, I suspect the industry will look a lot different than it does currently.

Banks have to find a way to grow in the current banking environment. Steven Hovde of Hovde Group outlined the situation banks find themselves in today. I have learned to pay close attention when Hovde talks at these events, as he really has his finger on the pulse of the industry. He is deeply involved in community banking -- running an investment banking and capital markets firm that specializes in the sector. In addition, he and his brother Eric hold controlling interests in banks across the country, and serve on the board of several banks.

In his talk, he pointed out that banks have to grow to be competitive in a tough marketplace. The larger you are, the higher the returns on assets and equity, as costs are spread over a larger base.

The relationship between size and returns holds steady until you cross the $10 billion mark -- where the extra regulatory requirements and sharper focus from the Consumer Finance Protection Board kick in. Banks under $500 million are earning on average about 65% of what larger banks earn, and for those under $1 billion in assets, the earnings gap as measured by return on assets is about 30%. The sweet spot, right now, has climbed from the $3 billion to 5 billion mark, and is now at about $5 billion in assets. 

Hovde made the point that to get bigger, you have to be more efficient. Banks are starting to focus on cost control, and for the first time in decades we are seeing branch closures as banks move to eliminate overheard costs. They are expanding mobile and internet services, as that is increasingly the banking option of choice for consumers. Whatever they can do to expand their returns on assets is on the table, as growth is not a choice anymore, it is pretty much mandatory. Grow or die is very much a reality in today's community banking world.

Net interest margins are at historic lows, and they are not going to get better anytime soon. There is no doubt that the Fed wants to raise rates, and Fed officials are talking up rate hikes this week in advance of the June meeting. But no matter how much they want to raise, the question is whether the data will let them justify a raise in rates. The most recent economic news has been okay, but any negative reports over the next few weeks will put them in a real bind. Low rates means low net interest margins for community banks.

In addition, costs are rising. And not just regulatory costs. Technology investment is becoming more expensive and cybersecurity costs are a huge hurdle that is just going to get bigger in the years ahead. Community banks are no longer competing just against other banks: non-bank lenders, payment providers and other fintech companies are now competing to offer services that were once the exclusive providence of banks.

While all this is sure to gives bankers a headache, it is great news for those of us who invest in community banks. The best path to growth today remains mergers and acquisitions. Every day, it seems we are seeing announcements of merger activity. According to Hovde, almost a third of bankers think that the best path to growth is going to be via merger. There are over 6,200 banks in the country, so that's a huge opportunity for community bank investors.

Owning a bank that gets taken over provides an immediate stock price gain. Owning a bank that makes a series of deals and grows from under $1 billion in assets to over $5 billion in a few years leads to long-term share price appreciation, as asset growth drives higher earnings and dividends. Either outcome is wildly profitable for bank stock investors.

It is not a great time to be a banker. The industry is facing serious hurdles from rates, regulators and new competition for banking customers. It is, however, a great time to be a bank-stock investor, as the grow-or-die mandate leads to either merger profit or high rates of long-term growth for our community bank stocks.

If you don't own community-bank stocks, you are making a mistake that is costing you money.

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