Banking Judo –Turning Size To Your Advantage With Credit

Community Bank Size As An Advantage

Having more bankers to throw at a borrower or more assets to flaunt does not make a bank more effective. Strategy beats size every time, but bankers need to be smart how to position themselves against large banks. When it comes to loan mix, community banks need to be careful to assemble their assets with enterprise risk in mind. In particular, the increase in commercial real estate (CRE) and specifically, High Volatility Commercial Real Estate (HVCRE) is starting to be a concern. To look into this, we pulled the most recent industry data and striated by total asset size. As billed, there are reasons why smaller community banks, in particular, should be careful of the construction of their real estate portfolio as some markers for concentration and return, indicate some community banks are being adversely selected. This is a function of strategy. 

Commercial Real Estate Lending As A Percent Of Total Assets

Industry Consolidation


We divided all the banks from the most recent annual FDIC data into 6 asset bands as shown in the table below and considered loan market share, average loan yield, ROA and other yield factors.


Bank Breakdown By Asset Size


A few observations are noteworthy.  First, the structure of the industry is such that there is a high concentration among the largest 33 banks that are over $50B in total asset size. This group controls 67% of the market despite accounting for less than 0.6% of the total number of banks. This material fact of the industry means that it should drive strategy for every community bank out there as that level of dominance can work against you or for you depending on how you choose to handle it.


Getting Pushed Around


Unfortunately, many community banks are passively choosing to be jostled by the industry. As can be seen in the table above, net interest margin (NIM) is higher at smaller banks with very few exceptions among the various asset bands.  Larger banks are earning less NIM, but generating comparable return on assets (ROA) (the difference in the ROA among the asset bands is not statistically significant).  Smaller banks demonstrate higher yield on all loans, higher yield on real estate loans and higher yield on commercial and industrial (C&I) loans.  While this is seemingly a positive attribute, this advantage is taken away due to higher overhead costs, lower levels of non-interest income and potentially greater risk. 


Risky Credits


For the same asset bands, we also considered the concentration of riskier credits based on CRE, HVCRE and some other items that have recently been highlighted by bank regulators.  While the data does not show anticipated future credit issues, it is meant to highlight loan categories that have recently garnered more regulatory attention.


Total Real Estate Holdings By Banks



Let us underscore some of the interesting information in the table above.  First, total real estate loan concentration is relatively even across asset bands (RE comprises about 36% of banks’ loan portfolios).  Second, CRE concentration is also relatively even across asset bands (CRE comprises about 10% of banks’ loan portfolios).  However, construction concentration (both 1-4 family and other construction and A&D) is very different across asset bands.  Smaller banks are much more concentrated in construction and A&D.  The largest banks hold about half of the construction and A&D loans in the country, but that loan category is only 1.5% of all loans.  In contrast, banks between $100mm and $10Bn in assets have three times the concentration of these same loans.  If the next recession is anything like the average previous recessions (not like the great recession) then credit losses sustained on construction and A&D loans will take a large toll on banks that are not properly managing their exposure to this sector.  Anecdotally, we believe that the larger construction and A&D loan portfolio at smaller banks is the result of mispricing of credit.  If this loan category was properly priced for credit risk, overhead cost and project risk, then more of this loan category would be held at the larger banks.


The other interesting information in the table above is the loan concentration in multifamily loans for banks under $500mm in asset size.  Multifamily has been a category identified by regulators as possibly sustaining credit strain in the future if vacancy rates rise, as predicted in certain markets.  Multifamily loan concentration for smaller banks is significant and this category should be monitored by all banks.


How To Fight Back


To combat these attributes, community banks must practice some banking judo to make the heft of size work against large banks. It is evident by the chart above, that many community banks are not paying attention to risk-adjusted net interest margin or return calculations. Being able to leverage a pricing and credit stress model allows banks to guard against adverse selection and ensure they are getting compensated for the risk.

Combining construction loans with permanent financing will not eliminate the risk, but, as we have reported before, in our tutorial (HERE), dramatically increases profitability and shifts the risk/reward in your favor.


Community banks must also consider developing specialties segmenting their customer base so that they can develop a strategic advantage in profitable banking areas. There are many profitable niches such as car dealers, hospitality, poultry farmers, funeral homes, private schools, trade associations, political candidates and a host of others that some community banks have chosen to specialize in within their state to great success.


Specialization allows a community bank to gather experience with a particular lending category to better understand the risk. With each customer within a segment that is added, risk is reduced through knowledge and understanding. This additional insight can alert the bank to problems and issues before they become a big issue. This strategy also is more efficient and lowers both customer acquisition and maintenance costs.


Of course, with segmentation come concentrations, which is why community banks also have to assemble their specialties to offset correlative risk. If the specialty is contractors, then it must increase their exposure to industries such as healthcare, technology and consumer products not to mention hold more capital and Treasuries.


While there are many advantages of being small, not having to focus on large and broad lending categories are one. Development, construction and multifamily loans are some of the riskiest areas of banking and community banks need to protect themselves against being the lender of last resort. When the business cycle turns, some HVCRE loans will experience rapid cash flow disruption, depreciating collateral value, and all this could happen in a higher interest rate environment – a triple whammy that would create a challenging workout environment.  Risk-adjusting pricing, developing specialties within C&I and an active approach to portfolio management will help offset some of this risk as well. In addition, combining construction lending with permanent financing to shift the risk/return profile in your favor will also help manage risk. If you think the industry is concentrated now, it will be even more so in the next 10 years after the next downturn.