Are local banks entering the age of austerity?


October 16, 2011

Local community banks have emerged from the recession with consecutive quarters of healthy earnings growth, but many see lean years on the horizon.

The spread is narrowing between the interest rates banks can charge on loans and the ones they pay for deposits, making it harder to make money.

At the same time, fewer and fewer healthy businesses are looking for loans, out of fear they may overextend themselves in the sluggish economy.

And the federal government is imposing a raft of new regulations, raising costs for compliance and placing new restrictions on income such as overdraft fees. The result is a coming squeeze on profits, forcing many in the industry to take a fresh look at how they do business.

Alexandria-based banking consultant Bert Ely advises small banks to examine whether they should continue offerings such as mortgage servicing or construction lending.

“Unless you have enough scale and can deal with all of the compliances,” Ely said, “you’re better off not doing it.”

Which sounds easy, except in a saturated market such as Washington customers can easily find banks offering multiple services, said Paul Aguggia, a banking attorney at Kilpatrick Townsend & Stockton, a law firm in the District.

“You can’t be a one-trick pony and expect to compete in this market,” he said.

Some analysts argue the tension could push weak banks into the arms of stronger ones in hopes of gaining scale. Others hope to grow organically, adding new product lines that generate fee income. Congressional Bank in Bethesda, for instance, now offers second-round venture capital funding and “green financing,” or funding for alternative energy companies.

“It makes sense to look for different verticals aside from commercial real estate,” said Congressional Bank chief executive John Lane. “It drives more revenue and can differentiate you in the market.”

For its part, Bethesda-based Monument Bank has been generating fee income from selling off the guaranteed portions of the Small Business Administration loans booked at the bank, a business it entered into in 2009, said president and chief executive H.L. Ward. A year ago, the bank also began originating residential mortgage loans for sale into the secondary market.

Cutting costs

Beyond adding products, many banks are looking to cut costs. Consultants say more banks are moving to outsource information technology and processing functions, as well as shrinking staff at branches.

“We’re telling our clients to take a look at their noninterest expenses and consolidate positions, not give out raises in some cases,” said Dennis Gibney, a managing director with FinPro, a financial consulting firm.

Institutions also have been cutting rates for certificates of deposit and money market accounts to lower costs.

So far that has not hurt deposits. Customers continue to stash more money in banks, as evidenced by the $7 billion increase in local deposits at the end of June.

Deposits at Monument, for instance, jumped 29 percent to $279.8 million, while Virginia Heritage Bank in Fairfax gained $103.5 million in deposits (Capital Business’s calculation excludes corporate and other nontraditional deposits).

The problem is it is harder to make money on those deposits. Net interest margins — a key measure of profitability that assesses the difference between what banks earn on loans and pay on deposits — continue to decline. The Federal Deposit Insurance Corp. reported that the net interest marginsfor all banks was 3.61 percent at the end of the second quarter, compared with 3.76 percent a year earlier.

Analysts expect that compression to continue in light of the Federal Reserve’s decision to keep interest rates low until 2013 and plans to trade short-term Treasuries for longer-term government debt to flatten the yield curve.

“A lot of banks are faced with situations where loans they made a couple years ago and securities they bought are now maturing, and when they go to reinvest those proceeds they can only reinvest at much lower interest rates,” Ely said.

The fee debate

Tacking on new fees or increasing existing ones is another way consultants say community banks could supplement their income.

But at a time when behemoth Bank of America is facing criticism for plans to charge debit card users a $5 monthly fee, community banks should use their nominal fee structure as a marketing tool, said Bernard Clineburg, chairman and chief executive of the McLean-based Cardinal Bank.

“It’s going to help us,” he said. “If they have fees and we don’t, where are you going to bank?”

Raising fees on checking and savings accounts came up at National Capital Bank’s executive board meeting this spring, but members decided the added revenue wasn’t worth alienating customers, said James Didden, president of the District-based bank.

“With more government regulations on what banks can earn, who knows, we might have to do some things in the future,” he said. “But [for now] there is no need to nickel and dime our customers.”

To be sure, the majority of small banks in the Washington area reported earnings growth in the second quarter. Bethesda-based EagleBank and Virginia Heritage Bank of Fairfax, for instance, registered gains of roughly 25 percent because of their increased lending. Other banks, such as Olney-based Sandy Spring Bank and Virginia Commerce Bank in Reston, reduced loan-loss provisions, the money set aside to cover bad loans, which bolstered income.

“Profits are there,” said David Danielson, president of Danielson Associates, a financial consulting firm in Bethesda. “Cost of funds have gotten so low that if you can make commercial loans and you don’t have any legacy asset quality issues, you’re going to make a good deal of money.”

But for how long?

“We’re dealing with a challenge of finding good quality loans. It’s very competitive and that competition is making our margins shrink some,” said Ward of Monumental Bank. “In June, we had about 15 percent growth over June 2010, where historically we’ve had 22 percent.”

Danielson said the pace of growth is likely to remain subdued for many in the industry: “They have to keep a little more capital and be a little more conservative on the lending and demand is not there.”

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