How Small Banks Manage to Provide Impressive Returns

Many community banks are showing why bigger doesn't always mean better when it comes to profitability and delivering solid investor returns.

Banks, particularly smaller ones, are dealing with difficult conditions for increasing earnings. Artificially low interest rates are squeezing margins, regulatory costs are rising and competition remains intense.

A number of banks with $2 billion or less in assets have figured out how to reward investors with double-digit returns, according to Capital Performance Group. Several broad trends surfaced in the firm's analysis of top performers: Niche lending matters, strong local economies help, and, in many instances, banks have to be willing to spend money to make money.

Each top-performing bank has its own strategy for success, industry observers said.

"The ability to grow the franchise is key," said Christopher McGratty, an analyst at Keefe, Bruyette & Woods. "A good manager that has a good opportunity can differentiate … based on their ability to grow the business model and attract capital."

"All of these banks are doing something a little bit different," added Michael Iannaccone, president and managing partner at MDI Investments.

High-performance banks, for instance, seem less willing to rein in expenses. Last year, noninterest expenses rose 7.4% at the nation's 500 top-performing community banks, compared to 4.38% for all community banks.

At the same time, those banks are producing enough revenue to more than compensate for the rising expenses. The banks with the best investor returns had an average efficiency ratio of 54.58% last year, compared to 70.81% for all community banks.

The results "lead us to believe that the efficiencies were created by investments in revenue-producing assets," said Kevin Halsey, a senior analyst at Capital Performance Group. "That is instead of doing cost-cutting."

A greater percentage of noninterest expenses at high-performance banks were tied to salary and benefits rather than premises and fixed assets, showing that such institutions are willing to pay up for talent and reward employees for good work, industry experts said.

"The high performers typically pay better, but they also expect more," said L.T. Hall, president and chief executive of consulting firm Resurgent Performance. "The culture revolves around a greater degree of accountability."

Culture is one of the driving forces behind the success at Citizens State Bank of La Crosse in Wisconsin, said Dennis Vogel, the bank's president and chief executive. The $163 million-asset bank achieved its three-year average return on equity of 23.2% by focusing on customer service, a strategy that Vogel said doesn't come cheap.

Citizens' expenses rose by 15% last year, while revenue increased by 11%. Despite the higher expenses, largely tied to an increasing work force, the bank's efficiency ratio remained below 49% and its net interest margin was a healthy 4.38%.

"If we weren't growing I could reduce staff by 30% to 40%," Vogel said. "But our standards are to always raise the bar. You have to be ahead of the curve."

The $693 million-asset Crestmark Bank had a faster growth rate for expenses, and it was less efficient than many other top performers. Crestmark focuses on business-to-business lending, such as factoring and asset-based lending, which requires a specific level of staff expertise, said W. David Tull, the Troy, Mich., bank's chairman and chief executive.

Still, the bank's return on equity averaged 22.1% from 2012 through 2014.

"We consider ourselves entrepreneurs and our client base is largely entrepreneurs," Tull said. "We understand the nature of being an entrepreneur and we know what it's like to have to make payroll."

Niche lending is another way that smaller institutions, like Crestmark, can become top performers, industry experts said.

"The two most important things are cost structure and a business model that can address the more profitable, but smaller, niches in lending," said Christopher Chouinard, portfolio manager at 1C Investment Co. "A good manager is out there looking for these inefficient areas of the market where there are extra returns."

Focusing on a specific area of lending lets a bank develop a strong level of expertise that allows it to more efficiently build customer relationships and make loans, industry experts said. This could include developing a consumer-oriented niche, including the residential mortgage focus at Federal Savings Bank in Chicago.

More often, it applies to the commercial side, industry observers said. For instance, Live Oak Banking in Wilmington, N.C., and NewBank in Flushing, N.Y., originate a lot of Small Business Administration loans.

Niche businesses can significantly boost fee income. Top performers generated a third of their noninterest income by selling loans, compared to 18% at all community banks, according to Capital Performance Group. Looking at it another way, high-performing banks generated just 18% of their fee income from service charges, compared to 26% at all banks with $2 billion or less in assets.

"Community banks need to be pretty rigorously focused," said Steven Reider, founder of Bancography. "They may have trouble making money in a Walmart-type of approach. Instead, they might be better off working as a Neiman Marcus - selling a few things at a higher price."

Crestmark is a "big believer in niches," Tull said. "We like niches. We choose a specific niche and then we want to become very, very good in that area."

Offices within Crestmark have a specific focus, Tull said. The bank's Nashville, Tenn., office works mostly in transportation, while the Baton Rouge, La., office works with suppliers to the oil and gas industry. Tull said the bank is able to diversify its loan portfolio by having clients in more than 40 states and by working with a variety of industries.

Finally, geography also seemed to aid many high-performing banks, industry observers said. Roughly 70% of the 500 top performers are based in 10 states, led by energy-rich Texas and Oklahoma. In comparison, the ten states have only 48% of the all banks with $2 billion or less in assets, Iannaccone said.

Declining oil prices have prompted banks in Texas and elsewhere to prepare for decreased borrowing and credit issues. While big oil and gas firms will likely be fine, smaller businesses that serve those companies may struggle, said Evan Tomaskovic, a partner at Carl Marks Advisors.

As issues surface, the list of top performers could change drastically, industry observers said.

"The management team is very important, but they can only do so much," Tomaskovic said. "Usually, it is not an issue that management is incompetent, but it usually has something to do with the macroeconomics."