The nation's community banks face a stormy future, and unless they change the way they do business their profits will deteriorate and might even disappear.
Even a decline in interest rates--which many bankers see as the solution to most of their problems--will not help profits much, if at all, at community banks, the consumer-oriented institutions that are typical of most of the nation's 14,000 banks.
That is the sobering warning the new comptroller of the currency has for the industry he regulates.
The comptroller, C. Todd Conover, said in an interview that the traditional source of bank earnings--the difference (or spread) between what a bank earns in interest on its assets (loans and securities) and what it pays out in interest on its deposits--is going to shrink.
At the same time, bank operating costs, such as salaries and equipment outlays, have been rising faster than the growth in assets.
At some point--and sooner rather than later, he says--community banks will face a severe profit squeeze unless they gain control over operating expenses and find new sources of income to augment the so-called net interest spread, which will be squeezed by rising costs of their deposits.
The largest of the nation's banks--the "money center" banks in New York, Chicago and California as well as many regional banks--have made the transition. While the typical community bank has a net interest spread of about 7 percent (measured as a percent of assets), big banks like Citibank and Continental Illinois operate profitably with spreads of between 2 and 3 percent.
The money center banks have sharply reduced their operating costs and derive a large percentage of their revenues from fees--charges for specific services such as issuing letters of credit and lines of credit for companies or maintaining checking accounts for consumers.
While all banks get some income from fees, the key to profits at most banks has been the pool of cheap deposits they could draw on to make their loans. As recently as 1976, 82 percent of all the deposits in the banking system were what banks call "core" deposits: checking accounts, passbook savings accounts and small certificates of deposit. The other 18 percent consisted of large deposits whose costs are tied to rates paid in the money markets, where banks, corporations and governments compete for funds. The bulk of the market rate deposits were in money center banks rather than community banks.
On average, core deposits cost banks about 2.5 to 3 percent in interest payments. Market rate funds--be they the purchased deposits of the money center banks or the new consumer deposits such as money market certificates--can cost 14 percent or more. The cost of a market rate deposit is much closer to the return a bank receives today on a loan.
In the last five years, core deposits have fallen from 82 percent of bank deposits to 49 percent. That percentage will continue to erode, Conover says, regardless of whether interest rates remain high or decline, and whether deregulation stops or the federal government continues to chip away at the ceilings on rates banks can pay depositors.
As a result, banks will not have the huge amounts of cheap deposits to draw on; more of their core deposits will shift to high-cost accounts such as money market certificates or will flee the banks altogether for money market mutual funds. The source of past bank profitability, the big interest spread, will narrow.
Bankers and borrowers alike fervently hope for lower interest rates. Borrowers, burdened by high interest costs and a recession, are having difficulties paying back their loans, and bad loans are piling up at financial institutions. High interest rates also are making it more expensive for banks to gather deposits.
If rates come down, borrowers will find it easier to repay, and banks can gather deposits more cheaply.
But Conover--in a series of recent speeches to local banking groups, including one this month to the D.C. Bankers Association--warned that lower rates are not the cure-all they seem. "There are no panaceas," he said.
If interest rates remain high and regulators continue to reduce restrictions on the amount of interest banks can pay on checking and savings accounts, the cost of core deposits will rise; at the same time, customers will continue to shift funds into money market, small-saver and other accounts that are more costly to banks, Conover said. Bank profits will come under severe pressure.
On the other hand, Conover said, if interest rates fall markedly and deregulation stops, the average cost of a bank's deposits will be lower than in the first scenario, but the yields on bank assets will drop so sharply that the spread between what a bank earns in interest and pays out to depositors could be smaller than if rates stayed high.
In both cases, Conover said, unless banks sharply reduce their operating expenses and increase the income they derive from fees, community banks will report shrinking profits. In a dire, but not unrealistic, hypothetical example drawn by the comptroller's economists, a community bank would report losses by 1986 if it doesn't change its ways:
Today that bank has assets yielding about 13.6 percent (20 percent of its assets such as buildings yield nothing, while the 80 percent in loans and securities yield 17 percent). Its liabilities cost about 6.8 percent of its assets (half the liabilities are core deposits that cost an average of 2.5 percent, another 40 percent are market-rate deposits that cost 14 percent, while 10 percent is net worth that requires no interest outlay). Its net interest spread, then, is 6.8 percent. The bank derives fee income equivalent to about 1 percent of the value of its assets and has operating costs of 6 percent, for a net operating cost of 5 percent. Subtracting the 5 percent from the net interest spread leaves the bank with a pre-tax profit of about 1.8 percent of its assets.
By 1986, if rates stay high and deregulation continues, many more deposits will shift from core accounts and the overall cost of the bank's deposits will rise from 6.8 percent of assets to 9.9 percent. Asset return will remain at 13.6 percent, for a net spread of only 3.7 percent. Unless the operating costs are reduced and fee income increased, the bank will report a pre-tax loss equivalent to 1.3 percent of assets.
If rates come down, Conover said, the cost of total deposits in 1986 will be about 6.5 percent, but the yield on assets will fall as well, to about 9.6 percent from 13.6 percent, and the spread will decline to 3.1 percent. Pre-tax losses, without changes in costs and fee income, will be equivalent to 1.9 percent of assets.
Conover, in a telephone interview, cautioned that the 1986 figures are projections. But they illustrate accurately his fundamental premise, he said, "that spreads will decline and bank profitability will decline."
Community banks will have to reduce branches, introduce more automatic teller machines, and raise fees on or shed unprofitable small accounts, he said. Many banks will have to choose their niche in the market, he said, rather than trying to be all things to all people.