Articles on Banking

June 21, 2006

Evaluating Community Banks

by James R. Miller

There is a predictability to the ebb and flow of community bank activity in the United States. Every seven to ten years, since the end of World War II, we have witnessed a resurgence in new bank applications submitted, and charters granted. This is usually followed by a period during which mergers and acquisitions have taken their toll

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There is a predictability to the ebb and flow of community bank activity in the United States. Every seven to ten years, since the end of World War II, we have witnessed a resurgence in new bank applications submitted, and charters granted. This is usually followed by a period during which mergers and acquisitions have taken their toll.

In the aggressive '80s hundreds of new community banks were chartered, plus a number of unsuccessful attempts to organize. Of those opened, some have prospered, some have failed, and many have merged or were acquired. So here it is 2002 and again many business and civic leaders in communities throughout the state are asking themselves the same series of questions: "what happened to our local bank?"... "why can't I get the service I need and deserve?"... "the banks that are left may be bigger and more efficient, but how does that help us?"... "whatever happened to local personalized service?"

I believe several factors explain why community banking is successful in the United States. Below I outline my optimism for their continued success and their importance to our economic fabric.

  1. Selectively investing in community banks over time has rewarded many investors. Growth in earnings and the accumulation of assets are the primary considerations for organizing or investing in a new bank. Investors who buy stock in a new business venture, generally make their decision after reviewing other success stories within the same industry. The bank investment process should follow the same route.
  2. The large National and Super Regional banks operating in the United States, typically focus their attention on major corporations for lending activity while gathering deposits via an impersonal electronic mass marketing process.
  3. The absence of layered management and committee structures allows for rapid decision-making, flexibility in the face of changing market conditions, and a greater responsiveness to the customer's needs.
  4. Specialization and niche marketing by a community bank can create lucrative opportunities in market areas that are neglected or not effectively served by larger banks.
  5. Few community banks must support large, costly, and outmoded branch networks.
  6. The Board of Directors, when composed of influential members of the community, make meaningful contributions to the bank by tapping into the community for loan and deposit business. They also influence operating policies specific to that market.
  7. Individual investors tend to support the value of their investment by directing business to the bank.
  8. Stock options to management and staff and Employee Stock Ownership Programs, provide a tremendous incentive for the employees to perform with shareholders' interests in mind.
  9. Community banks, collectively, hold less than 15% of the total of America's deposit base, leaving ample room and need for growth.
  10. Deregulation has revolutionized the banking industry, giving community banks the opportunity to compete on a more level playing field, and develop new profit areas that were not previously available to them. There are now more options open to deploy their resources, offering more products and services in order to cross sell to customers.
  11. Technology has helped create many new banking products giving community banks the ability to expand their asset base faster and less expensively than with the old-fashioned, brick-and-mortar branch system. This technology has become cheaper and more readily available, even to smaller community banks.
  12. A pattern has emerged in the community banking industry; successful local banks are being acquired by larger institutions. These mergers are often very favorable to the bank's shareholders. Potential investors should not overlook a potential exit bonus.
Over the past several years, many astute and successful Americans have been involved in community banks as organizers, Directors, Founders, or investors. Many of these banks have found their niche in the local market and as a result, their shareholders enjoy annualized returns between 12% and 15%. True, in the early ?90s, several community banks did fail. The economic downturn certainly was a factor. However, many failures were due, largely, to poor leadership. Yet, there are many community banks in the market that did not fail and continued to operate on a financially sound basis during those same difficult economic times.

Critical Issues to Review Before Investing In Community Banks

Location/Service Area

All successful banks are geographically located in an economically healthy service area. A solid business community with a stable population will provide the bank with a constant source of deposit and loan business. Look at the effects of long-term, not short-term, economic trends in the selected market. The service area should provide a mix of viable private and public commercial activity. Also, one should always evaluate the competitive nature of the service area, which will greatly affect the bank's growth potential. How many competing financial institutions operate in the trade area? What is the total deposit and loan base of the competition? Do organizations currently serve the niche upon which the new bank is focused? And if so, are they serving it well? In short, is there a compelling reason to organize a new bank, or is it perhaps just the organizers? egos that are driving the project? The answers to these questions, coupled with the investor's own sense about the market, will go a long way in helping them arrive at a sound investment decision.

Management/Board of Directors

The most important consideration, when speaking of the success or failure of a community bank (or any business for that matter), is the quality of management. The team of senior management and the Board of Directors is the force that guides the bank day to day. They must have experience, business acumen and enjoy community respect. The Director's positive community influence is essential in order for the bank to have credibility. In addition, management must meet the highest professional standards set by the regulators who monitor the industry. Beware of the bank that has too many Directors from a specific industry or profession or that is dominated by a single individual. Also, management and Board members collectively should own a substantial portion of the outstanding stock, but not so much as to override historical check and balance provisions. A minimum of 15% and a maximum of 35% of Board ownership has proven historically to be a good range.

Business Strategy

The successful community bank has a well-defined business strategy that focuses on promising segments of the market. By concentrating their business expertise and capital resources on selected market niches, the community bankers can more effectively compete with the larger chain banks and non-banking entities. Any bank or business that delivers quality service at a reasonable price and in a timely manner, will never be at a loss for customers.


Perhaps the greatest concern of many potential community bank investors is the issue of stock liquidity and how the after-market functions. The function of a market-maker is to provide a service whereby shares of a bank will be bought and sold at a fair price with adequate liquidity. This results in a precise process administered by professionals. An effective market-maker makes an active market in various community banks? shares. The goal of market making is to enhance liquidity of a bank's shares and reflect the earned accretion in value due to the fundamental performance of the bank. Market making is a relationship business. A market-maker works with the Board, management, customers and shareholders in a networking process to balance the supply and demand factors. Additionally, the market-maker will contact outside investors who have a particular interest in community banks. As these individuals and institutions take positions, they broaden the shareholder base not only in number, but demographically, thus potentially adding stability to the pricing structure.

Furthermore, the market-maker is prepared to take action and make capital commitments to create efficient markets in the client's bank shares. There must be ongoing communication between the market-maker's trading desk, brokers, their own client base and the client bank regarding the bank's current and prospective financial condition. This becomes critical when unexpected surprises in the marketplace occur. If all parties are continually well-informed, the possibilities of a severe downward price adjustment can be reduced.

It is important that the share price of the stock reflects the progress of the bank. Many times it does not. It is critical in today's environment of industry mergers and consolidations that a bank's stock also reflects a fair value. The stock of a bank can be thought of as its currency. Just as the dollar represents the USA and the Yen, Japan, so a bank's stock represents the bank. The professionalism provided by a market-maker such as Brookstreet Securities and their Community Banking Division focuses the attention needed to keep a bank's currency from devaluating.

Regulations/Mergers and Acquisitions

The recent passage of stricter banking laws regarding capital requirements and the mandate of regulators to take extra care before approving candidates for senior management positions strengthens the industry. Make no mistake, I fully support the regulators? position regarding stronger capital requirements and holding bank management to higher standards... The current and anticipated laws governing interstate banking have also affected the industry. Many banks changed hands on the speculation of interstate banking, while others are preparing for what they believe to be a profitable tomorrow. Many industry observers estimate that by the year 2005 there will be less than five thousand banks in the nation (there are currently just under nine thousand). Some doomsayers have even predicted that with all the mergers and consolations the community bank has outlived its usefulness. I could not disagree more. I feel the very fact that the public now has and will have even fewer choices, only makes a stronger case for the need of many to seek out personal, local, service-driven institutions.


Even the successful "non-banks," such as General Electric Credit Corp. and American Express Financial Services, join the chain banks and tend to focus on consumer transactions and/or their large corporate customer base. The local businessperson, professional and high net-worth individual find that they are not being served well by these entities. The large banks, however, just keep getting larger (witness the Wells Fargo/First Interstate and the Bank of America-Nations Bank deals). Further, I do not see that closing 350 branches, which was the fall out of the Wells-FIB merger, leads to better service for those Americans who demand personalized service.

On the other hand, community banks have demonstrated they can effectively compete against large banks by delivering quality service to selected segments of their local market. Well-capitalized community banks that are well managed and strategically located will continue to prosper. In doing so they can continue to be attractive investments. Under those conditions, there is no reason to believe that community banks will not continue to reward their shareholders with a reasonable return on their investment.

Published and edited by James R. Miller,

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