Community Banks Struggling with Fee-Based Diversification

Many community banks are finding that boosting returns by adding fee-driven businesses is easier said than done.

An annual community banking survey by KPMG also found that institutions are aggressively pursuing growth opportunities — increasingly from M&A — as they continue to pour money into compliance and information technology.

Nearly 90% of the survey's respondents said they have diversified by adding services such as wealth management, brokerage, insurance, trust or mortgages. But 37% said their return on investment for the new businesses has been zero or negative. Another 38% have seen a positive return of 3% or less.

While these findings are discouraging, John Depman, KPMG's national leader for community and regional banking, said they also suggest room for growth. He said banks must do a better job analyzing the costs and benefits of new businesses, while improving how they cross-sell to existing customers.

"The results indicate they're not necessarily getting out of [diversification] what they expected, so there's an opportunity," he said in an interview.

KPMG's survey, conducted in October, polled 100 executives at banks with $1 billion to $20 billion in assets. Respondents said that technology and regulatory spending are expected to be the two biggest cost contributors in the next year, with nearly half saying IT and 37% picking compliance as the top projected cost.

"Generally, the outlook is positive, and bankers are feeling better about where we are in the cycle, but there's work to be done," Depman said. "We've got a new regulatory regime, and now, it's an issue of how to expand the franchise and absorb the cost."

Views on regulatory costs are mixed. Compliance costs have been rising but also stabilizing in the past year, the survey found. Nearly 80% of bank executives said compliance eats up 5% to 20% of their operating costs, up from 74% a year earlier. None of the respondents said such expenses were taking up more than 30% of operating costs, compared to 6% a year earlier.

Regulatory costs "are definitely trending up and are settling in a range," Depman said. "To get it right, you need to spend somewhere in that 5% to 20% range."

Anti-money laundering and fraud oversight are the largest compliance budget items, followed by consumer protection, the survey found. But respondents said tech expenses are also a massive barrier to profitability, and 46% expect IT costs to rise in the next year.

Unlike compliance, bankers viewed technology as a huge opportunity as well as a cost. Most respondents had high hopes for data analytics in particular.

As tech spending puts more pressure on smaller banks to grow, the most common means of attracting new revenue are wealth management and M&A. Roughly a third of executives surveyed said they expect asset management to be the biggest driver of growth over the next three years, the highest of any responses, while 28% each said cross-selling and M&A.

The survey also suggested that the M&A market is poised for a strong pickup this year. The percentage of respondents who said they are "very likely" to be a buyer in the next year doubled to 22%, from 11%a year earlier, while very likely sellers ticked up to 14%, from 11% in the prior survey. Respondents with no plans for M&A fell to 23%, from 29%.

Nearly half of respondents said that an appealing customer base is the greatest incentive for an acquisition, followed by 36% prioritizing asset size and 25% choosing geography. Regulatory barriers are seen as the biggest impediment to M&A, followed by sellers' demands and balance-sheet issues.

The relatively low concern for balance-sheet issues reflects the overall industry trend toward greater health, accompanied with a shifting focus to growth and long-term strategy.

"The key takeaway from the survey is that people are now focusing on growth and strategic planning," Depman said. "The fire drill of the financial crisis at this point is under control."