Is It Game Over for Community Financial Institutions?

Some experts predict the gradual demise of traditional community institutions, squeezed by changed consumer habits, fintech threats and big-bank dominance. It's a bleak outlook for a big piece of the industry. Bank and credit union executives and other commentators say smaller players do have a shot ... if they adapt quickly.

In a press conference in November 2019, FDIC Chair Jelena McWilliams reported that community banks had another positive quarter in the third quarter. Net income rose and the annual rate of loan growth at banks up to $10 billion in assets outpaced the overall industry.

Despite that, in a podcast in January 2020, McWilliams said that “generally the viability of the community banking model is a huge issue for them.” She mentioned such challenges as rural depopulation, succession planning, and lack of scale to deal with cybersecurity as among the reasons. Looking ahead ten years, the FDIC chair saw two scenarios for community banks:

1. What she hopes for: Community banks have adopted and developed niche technology that works for their business model, putting them much closer to what the regionals and large banks can do. However, they are much more integrated with their communities than the larger institutions.

2. What she fears: Community banks didn’t make the investment in technology. The gap between the community banks and larger banks and nonbanks widens to become an “unbridgeable gorge.”

What do other industry leaders think about the future of community financial institutions? The Financial Brand reached out to a range of people, including senior executives at community banks and credit unions, asking them to address both the challenges community institutions face, and what will be required to meet them. Here’s what they said:

What are the biggest challenges to growth, profitability, or even existence faced by community financial institutions?

Economic and financial headwinds were cited by several people, including compressing margins, a low-rate environment and a “flat and low yield curve.”

“While the economy remains strong, we are likely late in the economic cycle, and the loans we make today will probably have to survive a credit shock,” states Chris Nichols, Chief Strategy Officer, CenterState Bank, Winter Haven, Fla. ($17 billion in assets).

“Consider that one mega bank spent more on technology last year than all 59 U.S. banks with $10 billion to $50 billion in assets combined.”
— McKinsey

McKinsey ticks off four other challenges besides macroeconomic conditions:

  • Consumer behaviors are changing. Switching banks is easy for people, giving them the power to unbundle their banking relationship.
  • Advanced analytics and artificial intelligence are becoming core differentiators.
  • The technology arms race continues to intensify. Consider that one mega bank spent more on technology last year than all 59 U.S. banks with $10 billion to $50 billion in assets combined.
  • Changing regulations, particularly concerning cybersecurity, could be challenging for smaller banks over time.

Several responders pointed to the increasing dominance of the largest U.S. banks. Millennials, who have grown up with technology and are used to doing business online, are picking the large banks, states Jim Reuter, CEO of FirstBank, Lakewood, Colo. ($19 billion in assets). “They make the leap that the big banks have the best technology, which may or may not be true. That poses a threat for the model of a community bank.”

JPMorgan Chase alone has account relationships with 50% of Americans, observes Sam Maule, Managing Partner for North America for 11:FS.

“Community financial institutions can’t afford to compete directly with the big players in technology,” states Joe Mirachi, President/CEO, Launch Federal Credit Union, Merritt Island, Fla. ($783 million in assets). “We need to have good digital systems that meet the market, but it is not realistic to think that we can differentiate ourselves with technology.”

Jim Perry market insights decision making processes quote

“The biggest challenges faced by community financial institutions are largely internal,” maintains Jim Perry, Senior Strategist, Market Insights. “At the management level, slow decision-making processes hamper meaningful progress.” The expense of replacing legacy systems and adjusting legacy competencies, Perry adds, often seems too large to tackle all at once. “Many community financial institutions chip away at these issues slowly, cautiously; only to fall further behind.”

Even for community institutions led by forward-thinking, next-gen leaders, the challenges are daunting. Balancing the transition from a people-focused business to technology delivery is one of the most significant challenges, according to Josh Guttau, CEO of TS Banking Group, Treynor, Iowa ($885 million in assets). “In my opinion we have to have both, not one or the other only.”

“Digital positioning and digital lead generation are the biggest threats I see facing community financial institutions,” warns James Robert Lay, Founder and CEO, Digital Growth Institute. “93% of consumers say they would start their journey shopping for a financial product or service online. That digital journey will eventually lead to a financial brand website, many of which are still nothing more than glorified online brochures.”

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Will the traditional community financial institution business model and revenue streams remain viable?

Given the above list of challenges, you would think the outlook for community banks and credit unions would be mainly negative. Yet the viewpoints were not uniform, ranging from the grim to cautiously optimistic:

  • “The challenges will continue to drive consolidation, and only the nimblest mid-cap and community banks will survive intact” — McKinsey.
  • “In many markets, the viability of traditional bank business models and revenue streams is absolutely in doubt — especially as the industry moves rapidly to align with an open-data economy. However, I would not rule out the segment of CFIs that are agile, innovative and capable of finding ways new ways to compete.” — Jim Perry, Market Insights
  • “We’re under attack from new competitors, but competition should make you better. I think community institutions are still a viable business model with the right technology and people in place and with other areas of growth than just loans.” — Joe Mirachi, Launch FCU

Jim Reuter FirstBank traditional revenue streams quote

Payment revenue in jeopardy. U.S. financial institutions under $10 billion in assets were carved out of the Dodd-Frank Act’s debit card interchange caps, but even smaller institutions are now starting to see that particular revenue stream as well as other payment-related revenue diminish.

So far, Launch FCU has maintained its interchange income, according to Mirachi. But by looking at their ACH files he can see members are using Venmo and other payment tools, which clearly is taking something away from the credit union. “Transaction revenue is definitely under attack,” he says. He worries about that revenue eroding and it’s one of the reason Launch is working with a CUSO (credit union service organization) to boost its business lending capabilities.

“Traditional revenue streams are going to come under threat over the next few years from real-time payments,” Reuter maintains. “Latency will be gone, which will reduce fraud. But in my opinion it will also enable customers to make better decisions around NSFs and that will lower NSF income.” Interchange income will also be impacted, he believes. “So two of banks’ biggest sources of non-interest income are going to be transformed by real-time payment,” says Reuter.

Read More: How a Small Iowa Institution Became The Bank Powering Big Fintech Apps

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How big a hurdle is scale for smaller institutions? Can it be overcome?

There was broad consensus among both banking executives and industry observers that scale was important. But almost no one thought it was insurmountable or simply a matter of total asset size. Reuter observes — with a touch of disbelief — that as his institution approaches $20 billion in assets, he’s now hearing for the third time in his career there that its business model won’t survive at that size. He first heard that when they were at $1 billion, and then again at $10 billion.

“Scale does matter,” he says, “but there are more strategic ways to compete in the digital era, such as through partnerships with fintechs and others, and being able to buy technology as a service versus a large capital expenditure.”

Rural institutions, however, are especially challenged with costs relating to technology and compliance, which decrease proportionately with scale, Jim Perry believes. He expects to see more technology collaboration among such institutions along the line of what Alloy Labs enables, but he also expects more mergers.

Joe Marachi Launch FCU under attack quote

“The biggest opportunity I see for scale comes through collaboration and alliances with other financial brands and even fintechs,” agrees James Robert Lay. “CFIs have an opportunity to share resources and technology. Banking is banking.” He even goes so far as to urge community banks and credit unions to “stop treating each other like the enemy” and collaborate to compete against big institutions and big tech firms.

Operating in markets ranging from rural areas to downtown Omaha, TS Banking Group pulled together three formerly separate banks into one group in 2014. “It’s easy to see that we can do things as a group that our individual banks would not have been able to achieve on a standalone basis,” says Josh Guttau. “That keeps them all relevant and staying up on the innovation/adaptation curve.”

Val Srinivas, Banking and Capital Markets Research Leader at Deloitte’s Center for Financial Services, states that while lack of scale will remain a competitive disadvantage in a low-growth, low-rate environment, it is possible for smaller institutions to survive and thrive if they invest in a modern operational and technology infrastructure.

“The quest for size is way overrated. Banks should forget about getting bigger and focus on how to become more efficient. A small community bank can achieve the same operating leverage as a bank that is 100 times larger. Any bank complaining about not being big enough should make sure they are doing all they can within their platform. It is crazy that it still takes 30 minutes to open a bank relationship in this day and age.” — Chris Nichols, CenterState Bank

What advantages do community institutions have in the new age of banking?

Although much of the above scenario is daunting overall, respondents felt community financial institutions do have several things going for them if they put them to good use. While all the financial institution executives view branches as a diminishing asset, the change will be gradual.

“We still believe that human connection is a way we can differentiate ourselves from competitors,” Mirachi states. “There is still 30% to 40% of the population that puts a value on that.”

Reuter adds that no matter how well your design things digitally, issues arise and consumers will have questions and expect answers.

“A combination of digital and high quality customer service is a powerful combination and something that I think frankly a community bank can get right.”
— Jim Reuter, FirstBank

“I don’t think the stakes have ever been higher at getting that right when you get the opportunity,” Reuter says. “We think a combination of digital and very high-touch, high quality in person or on-the-phone customer service is a powerful combination and something that I think frankly a community bank can get right.”

Another advantage of community financial institutions is that they are — or should be — closer to their market, and also can be a little more agile than larger institutions.

“It’s not all doom and gloom,” states Sam Maule of 11:FS. “There are plenty of examples of community institutions thriving. They do this by a laser focus on the unique needs of their community and customer base.”

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What changes must community institutions make to thrive?

Lots of feel-good rhetoric gets thrown around in community banking circles. It’s as if saying “We care about our communities” often enough will magically stave off the forces of change.

None of the industry participants we heard from expressed a sense of entitlement about community institutions. Some optimism, yes, but only if these institutions move adroitly into the future.

Here are a selection of the recommendations the group made for doing that.

“We’ve been talking about the importance of eliminating data silos for years, yet they still exist for so many CFIs. Moreover, if data is to be central to strategic decision making, CFIs must move beyond just talking about being data-driven and retool their systems and processes to support that imperative. — Jim Perry, Market Insights

“Moving forward, lending will be the key driver of community institution success. The CFIs that continue to perform best will be those with loan-to-deposit ratios in the 90-95% range. So institutions need to figure out what loan products they can excel at and how to differentiate themselves for those products to a target market.” — Joe Mirachi, Launch FCU

“If your onboarding experience and core service offerings aren’t fully digital, I’d be worried. My advice for you is to determine what key attribute is unique to your institution and create digital experiences and product offerings encapsulating this attribute. If possible, have your own small technical team build and sustain them. For other services, partner and look for great vendors and offerings.” — Sam Maule, 11:FS

“Success requires surgical investments in technology. Community financial institutions can’t invest in everything, so we have to look at what our customers are using and asking for and make investments accordingly. A good example is Zelle. Another is top quality mobile banking with money management tools. — Jim Reuter, FirstBank

“Future revenue streams can be created by bundling financial coaching programs with spending accounts (not checking accounts). People pay for coaching when they want real transformation… think gym, food, relationships, etc. They’ll do the same when it comes to their financial situation if the offer is positioned correctly.” — James Robert Lay, Digital Growth Institute

“The number one change is to move to a more innovative mindset. It’s crazy that financial institutions still largely price most of our products the same and deliver them in the same way. There is much more creativity that could be going on in banking and we shouldn’t leave it to the fintechs to come up with all the new ideas.” — Chris Nichols, CenterState Bank

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