How do small community banks survive?

I grew up in a suburban area outside of Cleveland, Ohio.  There were houses, businesses, and people everywhere.  The college I attended and graduated from was Miami University (in Ohio, not Florida).  It's located in a very small town in a rural area of Southwestern, Ohio.  One of the things I did in college was take epic bike rides through the Ohio countryside.  I'd skip classes and ride for hours exploring farms, finding new little towns and just riding to ride.  I did all my riding on a mountain bike, which goes to show that when you're young and in shape having the right tool for the job doesn't matter much.  On one of my rides I'd pass through a small town named Bath, Indiana.  I'm not even sure you could call it a town, it's more of a collection of houses, a grain elevator, a post office  and an enormous bank branch for the Bath State Bank.

Whenever I rode past Bath State Bank I would think "how do they stay in business? Who banks here in the middle of nowhere?"  I could never reconcile that a dozen houses and a grain elevator could keep a bank in business, let alone prosper to the level that they did as evidenced by their branch.

Fast forward 16 years and I still wonder the same thing when I pass through small towns with local banks.  How can a tiny town with a boarded up business district support two or three local banks?Welcome to the world of small community banking.

There are over 6,000 banks in the US, but the majority of these banks are small.  Of the 6,000 US banks only 709 have more than $1b in assets, and 4,808 are under $500m in assets.  Even more astonishing 3,189 have less than $200m in assets.  We can look even further and find 1,689 banks with less than $100m in assets.  Let's walk through the math on how a small bank like this can stay in business using Bath State Bank as an example.

The bank has $143m in assets.  They are earning 4.68% on their earning assets and pay .7% to fund those earning assets.  This leaves them with a 3.98% net interest margin, the difference between the two values.  From this they pay expenses such as salaries, back office expenses and whatever else is necessary to keep the lights on.  Bath State Bank was able to earn $1.4m in 2015, which is a reasonable return.  The bank generated a 10% ROE, a respectable return for a bank any size, but especially respectable for a bank that has under $200m in assets.

The question isn't "how can such a tiny bank stay profitable?" but rather "why does such a bank exist?"  Who are their customers?  Where in the world did that $143m come from if this bank is located in the middle of nowhere?  This is especially the case when one considers that the median income for most of these rural counties is less than $30,000 a year.  How much is someone making $27,000 a year able to save?  And how many families with $5,000 and $10,000 in savings does it take to hit $120m in deposits?

If one were to decide today in 2016 that they wanted to create a network of financial institutions to take deposits and make loans across the country I can guarantee that branch locations, and especially branch locations in small population centers would not be the model used.  But in the US we are living with the legacy of our past, and the past is the reason for the present.

From the founding of the US until the 1950s banks weren't allowed to have branches.  Each bank had its own building and a small town might have a half dozen competing banks, all in their own buildings, all doing business slightly differently.  From the 1950s to the 1980s government agencies slowly deregulated the banking industry and allowed branch banking, interstate banking and finally a regulatory banking free-for-all where anything was kosher until it met its end in the Great Financial Crisis of 2008.  The pendulum had swung too far, and now we're quickly swinging the other way towards increased regulation.

Banks, like small town hardware stores started where there was a need for their services.  If there was a crossroad with a railroad station then there was probably reason enough to consider starting a bank. This was back when pictures were black and white and men chopped down trees and farmed wearing three piece suits. As the banking industry has consolidated from over 14,000 banks in the mid 1980s to the current 6,000 banks a number of rural and small town branches have closed, but there are still many that remain.

While riding the "L" train in Chicago a few months ago I had a bit of an epiphany.  For those who've never been to Chicago the "L" train is an elevated public train system.  The system is a few stories up and weaves in and out of the city's downtown close to buildings and above the road.  While sitting in the train and roaring past apartment and office windows just a few feet from the track a though occurred to me.  This system that moves almost a million people a day couldn't have been built today.  No citizen of Chicago would allow a train to pass two feet from their bedroom window every five minutes if it were a newly proposed system.  But since this is a system that was built when the common good mattered more than the individual good, or when politicians just didn't care what people thought we have a situation where people gladly pay thousands a month for an apartment right on the main drag where window rattling is a feature.  This idea of investment isn't limited to public transit, it's most infrastructure in our country, and a lot of small business investments as well.  What was easy to build 50 to 100 years ago is impossible to build now.  Or if it were to be built now the project would be measured in decades and cost billions.  Many of the rewards we're reaping now are a result of investments earlier generations made.  How many small businesses are running and turning a profit with machinery that was built in the 1950s and has been fully depreciated for longer than most of their workers lives?

The same concept is true in banking, and even more true with community banking.  Up until recently banking was a relationship business.  People would build relationships with a local bank for decades and sometimes their entire lives.  My step-father-in-law lived in a small town in rural Ohio and still drives 35m out of his way to bank with the local small town bank.  He knows the names of everyone at "his" branch.  It's a testament to community banking that relationships can be built this strong.  The problem is that many banks put in the hard work to build those relationships decades ago and are now on autopilot and have never re-invested in new relationships.  There are a lot of very forward-thinking and progressive community banks that are still engaged in relationship banking.  They have established themselves inside valuable niches and are a trusted resource for their area.  But there are many more that are aging along with their depositors riding on the coattails of yesterdays investment.

Every once in a while I'll check out an older bank branch, or investigate a small town branch just to see what it's like.  I can tell when a bank is aging within minutes of stepping into the branch, sometimes I don't even need to enter.  These branches are time capsules for when they were built.  Want to know what banking was like in 1978?  There is a branch around here I can direct you to, it's perfectly preserved down to the carpet.  Feeling nostalgic for the 1980s?  There are thousands of branches sporting that luxury dark wood panel look where you can rest your body on a nicely worn period chair or couch.  For all the mockery the Post Office receives I've never been in a Post Office location that is as badly out of date as some bank's branches.

For a bank to thrive and grow they constantly need to acquire new depositors and generate new loans.  From the day a loan is originated it starts to pay itself down towards zero over a fixed length of time.  Banking is a race against the clock.  Generate enough loans each month to offset principle repayments and generate additional loans to register growth.  The same is true for a bank's deposits.  Deposits are usually steadier, but they age with their account holders.  Older depositors have more money and on average keep higher deposit balances.  But eventually these account holders pass away and their money is distributed to relatives, charity or wherever else.  Maximizing deposits is tricky for a bank.  They want older depositors with higher balances, but they need a constant flow of newer older depositors to counteract aging and death.

It is fascinating to observe an aging bank.  This is typically a bank that's in a shrinking town with a shrinking loan book and deposits that are dying and being passed onto heirs.  A common thread with these banks is their management is aging along with the deposit base, but they don't know what to do to fix the situation.  The problem is very few executives in their 70s will embrace spending significant amounts of money on iPhone apps or online banking websites.  Those things are for kids, not for serious banking like it was done in the 1980s.  And speaking of such let me take a slight diversion for a second. If you ever want to reminisce about the good old days I know of no better place than the annual meeting of many community banks.  I have found myself caught in conversations with bankers passing around stories from the late 1970s and mid 1980s like they just happened.  I'm all for story-telling and great war-stories.  But when the only stories are war-stories and the same executives are missing relevant issues of the day it's probably time for them to retire or recalibrate to what's important to the business today.  For better or worse the world has changed, and companies need to change with it.

The longer one thinks about this problem of aging banks the bigger the problem becomes.  We have thousands of aging community banks in aging areas that don't need these banks anymore.  Much of banking can be replaced with a phone.  I can deposit a check anywhere my iPhone has coverage.  I can transfer money while commuting on the train, or waiting for my food at a restaurant or anywhere.  I don't have to be physically present to do any of these activities anymore.  A human doesn't need to approve my deposit or withdrawal slip to conduct a transaction.  And this technology isn't just limited to customers who live in cities.  The US has become so blanketed with wireless and smart phones that anyone anywhere can conduct banking from the palm of their hand.

If a bank doesn't continually re-invest in new relationships then it has lost the only edge it had in business, the local niche.  A community bank can be flexible where larger banks cannot, but the bank can only be flexible if they are investing in the up and coming younger generation.  The best way to develop a lifelong banking relationship is with a customer when they're younger.  Young banking customers are loss-leaders.  A teenager with a bank account that rarely has a balance above $138 doesn't generate much in the way of income.  But as the teenager grows up, gets a job, starts a family, buys a house, and starts a business they will continue to add banking services and products most likely at the bank they started with, if they're treated well and given an opportunity to grow.

The natural question is what happens to these community banks that are on the edge of retirement?  I think eventually what will happen is a larger bank will buy them out, take their deposits and loans, close their branches and move branch banking online.  They keep a branch or two in the area that's well lit, updated, and modern.

I want to circle bank and answer my original question "How do small community banks survive?" the answer is "many don't."  For bankers, customers and investors I think we're witnessing an interesting time.  Since the financial crisis banks have been forced to adapt to a low rate environment.  Some have done this very well.  But others have decided to blame rates, politics, or the weather for their lack of investing and aging business.  We're witnessing what happens when small town banks that refuse to re-invest age themselves out of the market.  Many will sell to competitors across the street or across town.  And competitors will take what they've learned in the past eight years and turn sleepy deposits into profit engines through IT re-investment, increased cross-selling and other opportunities.

As investors we can profit from being on both sides of the table.  By owning aging banks on the cusp of retirement, or by purchasing banks that are buying aging banks.  For those that like the cheap flip look for banks trading below book value with elderly executives, shrinking deposits and shrinking loans all while maintaining too much capital.  For investors with patience and an eye for quality look for banks that are becoming successful serial acquirers for these retiring banks, buy in and hold on tight.

Interested in learning more about banks? Buy my book The Bank Investor's Handbook (Kindle and paperback available)


  1. Good post as always Nate, the aging deposit base is a massive headwind that I think is often unappreciated. Additionally, I expect when/if interest rates rise to see more deposit leakage as well. Few people will move banks for a .05% difference in interest rates, so comparison shopping isn't in vogue, but don't underestimate a retired person's willingness to buy an out of town brokered CD over a local one when the spread is wider.

  2. Thanks, the deposit headwind is big, potentially a bigger issue than anyone is talking about.

    Deposits are under appreciated. They can contribute to growth for a bank with a low ROE, as in a bank with a 7% ROE but deposits growing at 5% can significantly grow earnings. But also in the sense that they're a very loose funding base. Business deposits are pure gold for a bank, but banks with business deposits are few and far between. When one looks at most bank balance sheets "Time Deposits" make up the bulk of deposits, those are CDs held by senior citizens (primarily).

    I think I've told this story before, but if not I'll share again. I had a former banker tell me that at one point they needed deposits. They sent fliers to all of the seniors in the community offering .25% more than competing banks. They also offered free coffee for this deposit sale. He said the line of people waiting to open a CD extended out the door of the bank and onto the sidewalk. They ended up getting so many deposits they stopped the promotion early. He said it was entirely senior citizens and the place was mobbed, this was middle of the morning mid-week.

  3. The Fugitive 20th Anniversary - L Train

  4. Nice post Nate. Any micro/small-cap banks you can point towards as examples of forward thinking / deposit-focused / good capital allocators management teams? And are there any financial ratios or metrics you have found that signify a community bank might "get" it? i.e. deposit growth rates, % of business deposits, charge-off ratios, etc?

    Basically, with thousands of community banks out there and many trading at book value or below, what are the key criteria you find that make you lean towards Bank A vs. Bank B?

    1. These are great questions, let me answer by saying I'll do a follow-up post.

    2. Any updated thoughts on microcap banks with good management / shareholder letters and the ratios you focus on to decide?

  5. Nate, Have a couple of questions for you:

    1) Let's say you wanted to start a new bank today. How much does it cost? For instance, let's assume I want to open up a bank opposite Bath State Bank and win their business (their 143M in assets/deposits) assuming no switching costs, and I can instantly get their customers at no cost, how much start up capital do I need to earn their $1.4M net income?

    2) "There are over 6,000 banks in the US, but the majority of these banks are small. Of the 6,000 US banks only 709 have more than $1b in assets, and 4,808 are under $500m in assets. Even more astonishing 3,189 have less than $200m in assets. We can look even further and find 1,689 banks with less than $100m in assets"
    - Of each of these groups $1Bn, $500M, $200M, $100M how many banks in each group are trading below book value? i.e. P/B <1

    3) I hear people mentioned Price/Book and Price to tangible book. What's the difference? What is included and excluded?

    1. 1) Cost isn't an issue at this point, regulators aren't letting anyone start a new bank. In theory this is supposed to loosen up, but we haven't seen anything to indicate that yet.

      To your point to start a bank you need your initial capital, equity, but also some seed deposits. This is often why banks are started by ex-bankers (they already have the connections) or a group of business people who begin to bank with their own bank and introduce connections themselves. So figure you want to launch with $50-100m in deposits, you're going to need $10m in initial capital plus another few million in launch capital. Maybe $15m in total to start. For a de novo bank expect to lose money for 3-5 years before you break even.

      I wrote about local niches years ago. I think the ease of taking their business is on par with opening a new plumbing operation. In theory you could buy a van, buy all the wrenches and gear you'd need and open up. You could even undercut everyone's prices by 10%. In financial theory customers will flock to you because it's a rational decision. The reality is you'll be marketing and trying to sell yourself before people aren't rational and there are a million reasons why they use the companies they currently use. Inertia is powerful.

      2) Of the 6k banks in the US about 1k are traded banks themselves. The majority of banks that are public and trade are below 500m in assets. Off-hand I believe it's in the 700+ range. I haven't run a query recently, but if I had to shoot from the hip I'd say 150-200 trade at or below book.

      3) Tangible book or tangible common equity is equity minus all goodwill minus preferred stock outstanding. TBV discounts the preferred, and coming out of the crisis this was a big deal.

    2. Thanks Nate. Great answers.

  6. Regarding your quote below, why don't you think these "retiring" banks won't just slowly disappear? Why does it make sense for a larger bank to purchase them when the larger bank can just continue to take market share as the retiring banks customers die off?

    "The natural question is what happens to these community banks that are on the edge of retirement? I think eventually what will happen is a larger bank will buy them out, take their deposits and loans, close their branches and move branch banking online."

    1. It's easier to buy them and jump start the growth rather than whittle away at the market share. There is also a land rush mentality. You have a bank successfully gaining marketshare at 5-8% a year. They can grind this out forever, but a competitor can come in and with one transaction purchase 35% of the market and grow from there. No one wants to be the bank that was doing well growing organically only to find that everyone else was purchase and they're being run out of business.

  7. Very thoughtful, thanks Nate

  8. Community banks are in a way a de jure monopolies/oligopolies for many communities served. Because if regulators sense that an incumbent would be hurt by a new entrant the regulators will not issue a new license.

    Many community banks are de facto monopolies as well because the community may be over-capacity with 2 or more bank branches within town.