If you thought 2012 was aroller coaster ride for community banks, brace yourselves for next year.

Small banks are likely to find little relief in 2013, particularly when it comes to revenue. Indeed, credit quality is improving, but net interest margins are expected to keep shrinking and more regulation is all but guaranteed as Dodd-Frank implementation continues. And the industry seems less than thrilled about the results of the recent elections.

American Bankerrecently reached out to three banking experts, Jeff Adams at Monroe Securities, Richard Lashley at PL Capital and Joshua Siegel at StoneCastle Partners, to get their views of community banking in the year ahead. The following is an excerpt of their responses.

How would you assess the environment for community banks over the next 12-18 months?

JEFF ADAMS:Community banks continue to recover on the asset quality front, but it remains a slow recovery. As the challenges with problem loans recede, community banks will look for solid loan growth opportunities, but find demand still tepid. Over the past few years, we've seen more evidence of the regionalsemphasizing lending to smaller business clientson much better terms than community banks, providing an additional headwind for community banks looking to go on the offensive. 

Margin pressure will continue to weigh on the industry, squeezing spread income. Unlike the larger banks, community banks have little fee income to offset the loss of spread revenue, which will result in a more pronounced impact on earnings.

RICHARD LASHLEY:For most banks, credit issues have been dealt with or will be manageable without requiring capital raises or destroying profitability. The biggest challenge is mitigating net interest margin compressionwithout taking on excessive interest rate risk.

There is also the related issue of growing loans and revenue while dealing with a near-recessionary economy and the most oppressive regulatory and political environment in 25 years. The industry as a whole is earning about two-thirds of the [return on equity] they earned pre-crisis.  Profitability will grind higher, slowly, over time, but not get back to pre-crisis levels due to higher capital levels in the denominator.  About 90% of the industry is profitable, which is almost back to normal.

JOSH SIEGEL:Banks will face a dichotomy of performance metrics. On one hand, over 6,200 banks are profitable, well capitalized and earning an average 9.9% [return on equity] and have been underwriting near-pristine credit quality for at least three years, which foretells of low nonperforming assets and chargeoffs over the next four to five years .

Our sluggish economy, which I would debate never came out of recession, will prove challenging for banks in terms of loan growth and suggests continued low interest rates which will further pressure net interest margins.

What did the election mean for community banks?

ADAMS:Most bankers I work with believed that a change in administration would usher in a change in perspective about the importance of the banking industry to our country. While certain structural challenges face us regardless of who is running the country, I believe the mood change and morale improvement among small businesses would have set the stage for a better business climate.

Uncertainty is more of a threat to economic growth than who sits in the White House. With control of Congress split, I worry that continued gridlock will mean a reticence to make investments for future growth which, in turn,  impedes loan growth and hurts community banks' bottom line.   This means little capital will flow to the smaller names, [with investors focusing on] only the banks viewed as consolidators or those otherwise able to grow tangible book the fastest with the least risk.

LASHLEY:The election was the tipping point for many bank managers and directors. They have been inappropriately blamed and penalized for the financial crisis, when it is clear community banks were not the cause. Most bankers and directors wanted change in Washington in order to get some relief, both in regulatory practice and political rhetoric.

Community bankers and boards are fatigued.  The election may cause many small banks to realize they may not be large enough or sophisticated enough to be relevant and remain independent.  Many will sell to the highest bidder or find a merger partner in order to have the critical mass needed to survive. Anecdotally, I have heard that many were delaying strategic decisions until after the election.

SIEGEL:From a regulatory and policy perspective, an incumbent win reduced many of the identified unknowns that exist any time an administration changes. For community banks, it would be fair to assume more of the same market and regulatory conditions we experience today. Community banks, which are measurably different businesses than money-center and large regional banks in terms of risks taken, capital maintained and complexity of business, were hoping for regulatory relief, under both the Dodd-Frank Act and Basel III.  It is hard to staff and build for compliance when so many Dodd-Frank laws have yet to be written.  That said, this Administration has been reasonably community bank friendly, with a marked tone change from FDIC Chairman [Martin] Gruenberg, several Federal Reserve Governors and the Treasury Department becoming markedly more supportive.

What's the biggest challenge for community banks in 2013?

ADAMS:Assuming asset quality continues to improve for community banks as a whole, the low interest rate environment is a big concern.  In a quest for higher yields on earning assets, I'm nervous that many small banks will stray from sound risk practices and stretch on the investment side and the lending side. If this happens, we could see elevated losses persist.

LASHLEY:I already mentioned the revenue challenges from a lack of loan growth and margin compression. I don't see the Fed getting off the QE gas pedal, so residential and commercial real estate will be fine. Most banks will be challenged to realize that profitability will come from shrinkage and consolidation, not growth. 

The single biggest unexpected risk or challenge would be if the bond market vigilantes finally turned on the U.S. like they did on Europe. With the Fed in hyper-drive for another few years, I don't foresee that happening.  The U.S. will have its Greece moment, but it's further down the road.

SIEGEL:Depending on a bank's business model, geography, management team, shareholder base, capitalization, regulatory construct and asset quality, the challenges could range dramatically.  Three constants however that apply to all banks — although these are not necessarily the “biggest” issues a bank may face — are regulatory uncertainty, low interest rates and sluggish loan growth.

Will M&A pick up next year? What types of deals would you expect to see in 2013?

ADAMS:I believe we're already seeing a willingness of buyers and sellers to lock in to discussions in a more serious manner than at this point last year. 

Failed banks deals are slowing so many of the more-prolific failed bank acquirers are turning their attention to open-bank opportunities. Bank of the Ozarks' recent acquisition of a small community bank in Alabama is an example of that dynamic. We all know that deal pricing drives whether activity picks up or not. Until acquirers' stock multiples increase and the market at least takes a more balanced view of acquirer tangible book value dilution and earnings accretion, buyers will be hesitant to provide sellers  prices at much of a premium over tangible book.

LASHLEY:Deal activity will pick up in 2013. There will be a three- to six-year boom in M&A just like there was in the post RTC crisis recovery period from 1991 to 1997. Sellers will sell for all the reasons already discussed, including board and management fatigue, revenue and capital challenges and the election. Well-run banks will buy because the economics work, they need M&A to grow, they have currency arbitrage because their stocks are more highly valued than their targets, the cost saves are real and purchase accounting works wonderfully to kill the target's problems on day one.

The only impediments are regulators who are holding back buyers due to unrelated issues such as compliance MOUs and stress tests, and bank directors and CEOs who should sell but who are not paying attention to reality. Most deals will be part cash/part stock with some credit protection built in for the buyer pre-closing. It's a great time to be a bank stock investor focused on consolidation.

SIEGEL:I think it will pick up in regards to transaction volume. For community banks, we experienced an increase in 2012 over 2011, so I do not see any reason why the trend would weaken, barring some unforeseen external economic or political factors.  The industry is ripe, maybe over ripe, for broad consolidation, driven by the recent crisis, regulatory changes, aging bank management teams and boards. I expect to see more small banks merge rather than a wave of larger bank consolidations.

Two key items that continue to slow the process are capital and valuation.  Since GAAP converted to purchase accounting from pooled accounting, the old math of 1 1=2 became 1 1=1.7, because of the mark-to-market of the acquired bank's balance sheet. The gap needs to be filled with capital ,and the lack of capital available for smaller, especially private, banks continues to slow the process.

How can small banks create shareholder value in 2013?

ADAMS:Many community banks are operating with a cost structure more appropriate for an economy growing at double the current rate. I believe you'll see some income improvement from a right-sizing of overhead costs. Further, I believe you'll see more boards come to terms with the fact that waiting two to four years to sell isn't a reasonable strategy. Many community bank boards will come to the realization that trading into the currency of a faster growing, more liquid partner is best for shareholders. 

Regarding missteps, reaching for good loans is a concern, as is banks moving aggressively into C&I lending without sufficient experience and risk controls. The biggest risk is more big picture. Hoping things improve is a poor strategic plan. If banks can't realistically articulate to their shareholders that it can provide a return, as an independent, that exceeds shareholder expectations, they owe it to shareholders to combine with a partner that enables shareholders to have expectations satisfied.  

LASHLEY:Well-capitalized, high-performing banks should buy back stock and increase dividends, pursue accretive M&A deals, adopt new technology and cherry pick lending and branch talent from weaker competitors. High-performing banks will never get a better chance to grab market share and consolidate their markets. Weak performers and undercapitalized banks need to shrink to grow profits and increase capital ratios, by closing branches, shedding low yielding assets, letting high cost deposits roll off, reducing head count, and aggressively working out bad assets. The Fed has made low-cost bank deposit gathering easy.

The biggest misstep a community bank can make is to fail to understand that their franchise value is no longer mainly in their deposit base. It is in their ability to grow assets and profitably deliver more products and services per customer. Most small banks are capable of surviving but not prospering in this environment.  The smart management teams and boards will find a larger, more relevant bank to partner with. That will be good for their customers, the banking system and shareholders.

SIEGEL:Shareholder value is driven by only a few variables: deposit base, equity book value, valuation multiples and asset quality. While I admit this is an oversimplified approach to shareholder value, in many respects these variables represent the preponderance of the value equation. Banks should focus on retaining and building their deposit/customer base, through customer service and technology. Retained earnings or capital raises deployed into attractive opportunities will increase book value. Valuation multiples are largely out of the hands of management but not entirely; good PR and a clean balance sheet have consistently been rewarded by higher market valuation multiples to book value. A pristine balance sheet has been highly predictive of shareholder value, both in retention of book value and the market multiple to book at which a bank's stock trades.

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