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Business model risk at community banks
Robert DeYoung University of Kansas
Director, KU Center for Banking Excellence
April 9, 2013 6th Annual Risk Conference
Chicago Fed/DePaul University
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I want to briefly discuss four themes
1. Is the small bank business model still viable?
2. Regulatory risk.
3. Demographic risk.
4. Interest rate risk.
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How big does a community bank have to be?
• Small banks are financially viable.
• Exceptions:
• Tiny banks
• Poorly managed banks
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0
2,000
4,000
6,000
8,000
10,000
12,000
14,000
16,000
1980 1985 1990 1995 2000 2007
0
100
200
300
400
500
600
700
800
900
1,000
1980 1985 1990 1995 2000 2007
Data: FDIC.
Assets less than $500 million
Assets more than $1 billion
$500 million to $1 billion
Change in # of U.S. banks since 1980
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0.06
0.08
0.10
0.12
0.14
0.16
0.18
0.02 0.03 0.04 0.05 0.06
Me
an
RO
E
Standard Deviation of ROE
assets > $25B
$10B to $25B
$1B to $10B
$500M to $1B
assets < $500M
Data: Federal Reserve, author’s calculations. 5
ROE-Risk for U.S. banks and BHCs in 1998-2007. (Annualized averages based on quarterly data.)
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1 Citigroup $2,220,866
2 Bank of America $1,535,684
3 JPMorgan Chase $1,458,042
4 Wachovia $719,922
5 Deutsche Bank $579,062
6 MetLife $552,564
7 Wells Fargo $539,865
8 Washington Mutual $349,140
9 U.S. Bancorp $222,530
10 SunTrust Banks $180,314
Largest Financial Holding Companies by Asset Size, 2007
Data: Federal Reserve, FDIC.
Insolvent, Bailed Out
Insolvent, Bailed Out
Insolvent, M&A arranged
Insolvent, M&A arranged
Only about 6% of smaller banks failed since 2007!
40% failed
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Why did so few small banks fail?
2005 performance for banks with assets less than $500 million
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2005 performance for banks with assets less than $500 million
Banks that failed in 2008-2010
Banks that survived
Why did so few small banks fail?
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2005 performance for banks with assets less than $500 million
Banks that failed in 2008-2010
Banks that survived
ROA 1.07% 1.17%
ROE 11.8% 11.1%
Provisions-to-assets .0029 .0024
Why did so few small banks fail?
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2005 performance for banks with assets less than $500 million
Banks that failed in 2008-2010
Banks that survived
ROA 1.07% 1.17%
ROE 11.8% 11.1%
Provisions-to-assets .0029 .0024
Asset growth (2000-2005) 182% 59%
Core deposits-to-assets 55.6% 68.1%
Loans-to-assets 74.8% 63.1%
C & D loans-to-total 23.6% 7.6%
Business loans-to-total 18.0% 23.5%
Why did so few small banks fail?
These data are consistent with recent, more careful research done by Rebel Cole (DePaul) and Larry White (NYU).
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“New regulations are making the small bank model less viable.”
• CFPB (at least for now) is aiming at banks
with assets over $10 or $20 billion.
• Basel III requires more capital and higher
quality capital. Especially expensive for
community banks.
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Where will equity capital come from?
• Cheapest source of capital is retained earnings.
• Example: A $150 million bank with ROA = 1% and leverage ratio of 10%.
– Retain 100% of earnings equity increases by 10%.
• Bank can quickly meet higher capital standards.
– At this 10% growth rate, equity will double in 7 years.
• If ROA=1% opportunities exist, assets can grow at 10%.
• Is 10% real growth fast? Between 1990 and 2007:
– the median U.S. bank grew at a 2.8% real annual rate.
– moving from median to 75th required a 7.8% real annual rate.
• Less useful for S banks (distributions to pay taxes).
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The next generation of retail customers wants a different type of banking
relationship.
• “High touch” customers.
• “No touch” customers.
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Small banks must be relationship based.
• Re-think what a retail banking relationship means.
– Adding mobile banking is necessary but not sufficient.
– Cultivate a “low-touch” relationship.
• Your coffee is never going to be as good as Starbucks.
• Two contrasting images for the Internet generation:
– Bankers are part of the “1 percent.”
– Small/local banks are “sustainable.”
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Waiting for Bernanke.
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Large banks betting on rate increases? Smaller banks close to neutral.
U.S. Bank Holding Companies Median Averages
2012 Fourth Quarter Data
Asset Size Re-pricing Gap (% of assets)
More than $100 billion +22.2%
$10 to $100 billion +15.2%
$2 to $10 billion +8.3%
Less than $2 billion +3.8%
Moreover: These re-pricing gaps have been growing more positive since 2009 for all sizes of BHCs.
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Interest rate exposure
• Interpretation?
– Small banks poorly positioned to exploit coming rate spike?
– Small banks well hedged against coming rate changes?
• We all know rates will eventually go up.
– But when?
– Small bank business model is about relationships, not interest rate speculation!
• Floating rate loans are the best hedge. But…
– Your market may demand long-term fixed rate loans.
– The initial premium on fixed rate loans: Use it to purchase interest rate swaps.
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Business model risk at community banks
Robert DeYoung University of Kansas
April 9, 2013 6th Annual Risk Conference
Chicago Fed/DePaul University