The Biggest and Smallest Banks Will Remake Banking Landscape

Community lenders will compete for deposits against banking giants in coming years.

By Renuka Rayasam, Associate Editor, The Kiplinger Letter

October 9, 2008

Small community banks will race to protect their turf and fight for new customers in the remade financial services landscape. What the smaller players must contend with are the biggest banks, competing for their customer savings deposits.

"For years there has been speculation that financial services were becoming a barbell with a heavy number of large and small banks," says William McCracken, chief executive at Synergistics Research. "Now that trend has accelerated."

Investor panic is speeding up a decades-long consolidation in the financial services industry. There are about 8,500 banks -- down from 17,000 in 1988. As their stock prices swooned, the investment banking giants disappeared -- merging, buying or being bought by the three universal banking giants that now hold almost a third of U.S. deposits: Citigroup, Bank of America and JPMorgan Chase.

The consolidation is far from over. Regional midsize banks with assets of $10 billion to $50 billion are attractive targets for these banking behemoths. As fear continues to drive investors to pull their money out of financial stocks, even healthy banks will have to put their assets up for sale rather than fail.

The crisis creates competition and prospects for community banks in coming years. "Some of the small banks will actually benefit if a behemoth gets swallowed," says Edward Woods, senior analyst at Celent. "It creates a lot of confusion, but also a sales opportunity."

Many customers will be shopping for a new bank as their old bank is acquired or goes under. "The natural audience for community banks is disappearing," says Charles Wendel, founder of Financial Institutions Consulting. Look for smaller banks to partner with other banks and credit unions to expand their ATM networks. Talented bank executives will be put back on the job market, often at lower salaries than what they were earning before in an economy struggling to get back on its feet.

The advantages community banks offer are nimbleness and relationships. Bank owners can act quickly making decisions around a dining room table without worrying about shareholders or their stock price. "That allows community banks to react very rapidly and stay close to customers to make decisions on a dime," says Camden Fine, president of the Independent Community Banker's Association. Small banks, as a result, are more likely to renegotiate loan terms for struggling borrowers without having to go up the chain for approval.

Small banks will have to work hard to benefit from the unusual circumstances. "This is a wake up call to retrench," says Woods. "But they have to be diligent, because what is not going to happen is everyone just throwing money at little banks." Small banks will continue to emphasize local ties to their community in order to reassure worried depositors and win more customers who value face-to-face relationships with their banker. That means more local advertising; supporting local groups, such as the area little league team, and continued involvement in local charities and community events.

Comparable to banking giants that offer a wealth of interlinked services from 401(k)s to mutual funds, smaller banks will partner more with other banks and credit unions to expand their ATM networks. They will also work with existing technology vendors to push harder into online and mobile banking. Some banks are offering reward programs similar to credit card companies, which offer trips or discounts at local restaurants and retailers. Others are testing interest bearing checking accounts to lure investors fleeing the stock market.

The next 12 to 18 months will be treacherous for banks, especially those hard hit by the credit crisis in California and Florida. Small banks are more apt to be overextended in commercial real estate, which could be the next danger zone.

As the economic downturn deepens, profit margins will dive and returns will be harder to generate. The smaller community banks that fail will be too small to be bailed out or bought. But the ones that survive will thrive alongside their bigger rivals.

For weekly updates on topics to improve your business decisionmaking, click here.