Last fall, our lead article in this newsletter detailed the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act that would have the biggest impact on community banks.
Since then, there has been a lot of discussion in the industry about what financial reform will mean for community banks in the long run. While no one has a crystal ball to predict exactly what the community banking landscape will look like years down the road, a bit of clarity is starting to form in some areas.
Higher Capital Requirements = Lower ROE
What’s indisputable is, in the new post-reform banking world, financial regulators are mandating that banks maintain higher levels of capital and equity. As equity is raised relative to assets, return on equity (ROE) and, hence, one measure of profitability, will be reduced.
In a recent survey of investment bankers and financial industry consultants, it was estimated that for community banks with less than $500 million in assets, return on assets (ROA) would range from 50 to 85 basis points (bps) and ROE from 6 percent to 8 percent by 2013. This level of return will be unacceptable for most community bank investors, who generally look for returns of 11 percent to 14 percent. (See sidebar for more survey results.)
It’s clear that going forward, one of the biggest challenges for community banks will be raising capital in an environment where ROE may be considerably lower. For one thing, Basel III imposes higher capital requirements on banks. Also, new Trust Preferred offerings are no longer acceptable as regulatory capital. In this environment, community banks have two choices: either generate more revenue per each dollar of assets, or more profit per each dollar of revenue.
Typically, banks have accomplished the former through fees. But Dodd-Frank limits how much banks can charge merchants for debit card transactions (or interchange fees). Even though banks with less than $10 billion are exempted from these limits, the reality is that many community banks will be forced to lower their interchange fees in order to remain competitive. It’s estimated that banks’ interchange fee income alone could be reduced by up to 50 percent. Meanwhile, new regulatory guidelines limit how much banks can charge customers for insufficient funds overdrafts (or NSF charges). As a result, the two primary sources of non-interest income for banks — interchange fees and NSF charges — will be significantly reduced going forward.
And don’t forget about the repeal of Reg Q, which may result in community banks paying interest on business deposits, and new limitations on accepting brokered deposits. The bottom line: At the very time banks need to generate more net interest income, they will be limited to generating less.
Incremental Interest Income
On the interest margin side, the best vehicles for community banks to generate more profit per dollar of revenue have traditionally been residential mortgages, acquisition and development and construction loans, and commercial real estate (CRE) loans. You don’t need us to tell you what has happened to these types of lending the past few years. Also, regulators have effectively capped CRE and construction loans at 300 percent of capital.
And on the expense side, financial reform places a greater regulatory burden on banks of all sizes through new disclosure and reporting requirements, obligations and provisions. These include new Home Mortgage Disclosure Act (HMDA) reporting obligations and new rules designed to discourage discrimination based on gender, race or ethnicity. While banks of all sizes are subject to these requirements, they will likely result in disproportionately higher compliance and regulatory costs for community banks in comparison to larger banks, which will benefit from economies of scale.
Finally, there is the big unknown of what will be the impact of the Consumer Financial Protection Bureau (CFPB), the new federal agency tasked with protecting consumers’ financial interests. While the CFPB will not supersede regulators’ authority for examination of banks with less than $10 billion in assets, the agency will have wide discretion in deciding what constitutes “unfair, deceptive or abusive” business practices.
Strategies for Survival
To succeed in the challenging environment that lies ahead, community banks will need to develop a comprehensive strategic plan. Here are a few survival strategies to consider:
• Identify alternative sources of loans and develop alternative sources of fee income.
• Enhance collection of existing fees.
• Build core deposits.
• Develop a strategy for dealing with the competitive implications of Reg Q.
• Employ risk-based pricing.
Look for more on the impact of financial reform on community banks in future issues as the situation clarifies. We can help you devise a survival strategy in the post-reform world of community banking. Call us today to learn more.