As part of their Community Banking in the 21st Century Research and Policy Conference, held annually, the Federal Reserve releases a selection of research papers that examine conditions and performance in the sector. Being a geek, I naturally read them all -- and several of them have conclusions that can guide us as community bank investors.
The first study I found interesting and useful was "Has the Relationship between Bank Size and Profitability Changed?" by Kristen Regehr and Rajdeep Sengupta of the Federal Reserve Bank of Kansas City. They looked at the relationship between size and performance, and concluded that "Our results support industry analysts' view that there are significant scale economies in banking, especially for the smallest community banks. However, this is not merely a post-crisis phenomenon. Throughout our sample period, small community banks have exhibited significant scale economies." In other words, size matters for community banks. Gaining size allows the fixed costs of regulation and compliance to be spread across a broader asset base.
They did find that there are paths to profitability beyond just growth. They noted in the study that "our results show that favorable market outcomes and changes in other bank-specific characteristics also increase returns. In achieving higher profitability, small changes in bank-specific and market-specific factors are equivalent to large changes in size. Therefore, banks need not grow larger to be successful: Business strategies and local economic growth are no less important in determining bank profitability than size."
Applying this to the practice of investing, it makes sense to look for banks that operate in a stronger economic region of the country. Banks in cities where the economy is robust and growing will have an easier time of achieving decent growth that allows them to out-earn the rising costs of regulation and technology.
In their study "Is Bigger Necessarily Better in Community Banking?" Joseph Hughes of Rutgers University, and co-authors Julapa Jagtiani and Loretta J. Mester of the Federal Reserve, also examined bank size and performance. They concluded, "Overall, our evidence shows that, on average, large community banks outperform small community banks. This may reflect that the costs of regulatory compliance and technology both have a fixed cost component, which results in there being a size below which the costs outweigh any lending advantages a small community bank might have."
They also noted that "Our findings, taken as a whole, suggest that there are incentives for small banks to grow larger to exploit scale economies and to achieve other scale-related benefits in terms of credit-risk monitoring." In other words, grow or die a slow, painful death.
We hear a lot of talk these days about the disappearance of traditional banks, as the whiz-bang technology companies will make old-fashioned banking obsolete. In their study "Is the Traditional Banking Model a Survivor?", Vincenzo Chiorazzo, Vincenzo D'Apice, and Pierluigi Morelli of the Italian Banking Association, along with Robert DeYoung from the University of Kansas, found that the closer banks stick to traditional, branch-heavy, relationship-based banking, the less likely they are to fail. They found that banks that have the four old-fashioned characteristics of a community bank -- relationship lending, core deposit funding, revenues generated from traditional banking products and services, and intensive use of bank branches -- are about 19% more likely to survive a crisis or downturn that a non-traditional bank.
They closed with an important caveat that has great import for us as community bank stock investors. They said, "Our results imply that the traditional banking business model provides a viable strategic harbor for small (but not too small) commercial banks to thrive in the future. But our results are based on data from a pre-Basel III, pre-Dodd-Frank regulatory regime. Going forward, the fixed costs of complying with increasing stringent supervision and regulation may weigh disproportionately on small banks, and erode the survivability advantages of the traditional community-banking model revealed in our estimates." That is the heart of the trade of the decade right now.
Small-bank stock investing is somewhat counter-intuitive for investors. We are not looking to buy the best and the brightest of banks. We are looking to buy those banks that are struggling to execute for reasons beyond their control. They must find a path to growth, which probably means a series of acquisitions, or carve out a niche that is powerful enough to overcome the weight of regulatory and compliance costs. Either of these outcomes will likely result in a higher stock price. Failing to achieve one of those two outcomes, they will have to sell the bank -- and that will lift the stock price. Get big or go home is the rule of the day in small banks right now, and it is going to be that way for a long time.
Tomorrow, we will look at some banks that have been struggling to grow and may face the Get Big or Go Home ultimatum sometime soon.