Top banks under $2B: Leading small banks ride NIM strength

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For all the change and challenge to arrive in 2023, the nation's most financially successful small banks entered the year with exceptionally strong credit foundations and stellar profitability metrics that could position them well to navigate headwinds.

In fact, the top three publicly traded community banks with less than $2 billion of assets in 2022 were the same companies that commanded the peak of the rankings a year earlier. Atop the list published annually by American Banker were No. 1 University Bancorp in Ann Arbor, Michigan; No. 2 Oregon Bancorp in Salem, Oregon; and No. 3 FinWise Bancorp in Murray, Utah. (The order among the three did change. See here for a full methodology on how the ranking is determined.)

Claude Hanley, a partner at Capital Performance Group, said that while all banks face a surge of new obstacles this year — from recession threats to mounting funding costs in the wake of three prominent regional bank failures this spring — the banks at the very top of the rankings and throughout the overall top 200 list tend to make repeat appearances over the span of years. This suggests that, while hardly immune to intensifying competitive pressures and macroeconomic threats, they have proven histories of above-par performances that give them both momentum and proven business models that are more likely to endure through difficult times.

"These are banks that know their borrowers well, and they aren't running up the warning flags," said Hanley, whose firm compiles the rankings each year. For them, "it's a question of growth and how much profitability."

The same applies to high performers overall. From CPG's data behind the rankings, for example, the median return on average equity for the top 200 banks under $2 billion of assets in 2022 was 14.16%, compared with 11.67% for the broader group of banks of similar size.

At issue this year, of course, is the fallout from the downfalls of Silicon Valley Bank and Signature Bank in March. The failure of First Republic Bank followed in early May. The collapses were induced, in part, by runs on the banks' deposits. What followed was ramped up competition for funding and an acceleration in already high deposit costs. Such expenses were on the rise following multiple Federal Reserve rate hikes to combat lofty inflation.

Higher rates bolstered lending profitability — a positive in 2022 — but also drove up banks' deposit costs.

Even before the failures, many in the industry were bracing for economic tumult and, by extension, increased likelihood of cracks in credit quality. Then storm clouds darkened further.

Michael Jamesson, a principal at the bank consulting firm Jamesson Associates, said in a recent interview lenders are increasingly worried about a downturn after the failures. The specter of loan losses looms large when the economy slows and, as such, community bankers could pull back on lending.

"If bankers are too conservative with credit, it will be a self-fulfilling prophecy," Jamesson said. "If things don't calm down, we're going to have a recession."

Even ahead of the bank failures, business owners and bankers were concerned about rising interest rates intersecting with inflation. When rates rise rapidly, borrowing costs increase and loan defaults tend to follow. The Fed is boosting rates to tame inflation, but it is a gradual process. The combination of high rates and lingering inflationary pressures historically has crippled the economy. 

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"Seeing these banks fail, it just exacerbates the situation," Jamesson said.

Analysts at Piper Sandler said banks are bound to pull back on lending to focus on deposit gathering and minimize their credit loss risks. This could substantially limit the availability of credit and tilt the economy into a recession. It would also eat into profitability.

"Virtually all the banks in our coverage universe … reined in their loan growth guidance" for the second quarter of this year. "Based upon this dynamic alone, we believe that a credit crunch is building which will surely have negative implications for the economy as a whole," Mark Fitzgibbon, Piper Sandler's head of research, said in a recent report.

Ahead of all that, however, leading small banks positioned themselves well.

The top 200 banks under $2 billion of assets in 2022 posted a median NIM of 3.46%, or 4 basis points higher than the broader peer group, supported by greater loan volumes. The leading banks posted median net loan growth of 13.25%, higher than the peer group's 12.75%.

The top banks were able to bolster lending while maintaining pristine credit quality. Among the top 200, the median ratio of nonperforming assets as a percentage of total assets was just 0.25%. For the broader group, it was 0.27%.

"I think there is a lot of strength, a lot of ability among community banks to persevere this year and thrive long term," Robert Bolton, president of bank investor Iron Bay Capital, said in an interview. "Most community bankers are risk averse; they know to take care of credit quality. They also know their customers and know their markets, and that enables them to identify opportunities and avoid vulnerabilities, and the ones that are best at that tend to be pretty darn successful over time."