If all you knew about banking ended at customer relationships and cost management, you would be puzzled over the existence of large regional banks. How could an institution with a regional footprint outmaneuver community banks (which, you would surmise, have a better grip on their local markets) while also competing with the national brands that have deeper pockets for advertising and technology.

You might even conclude that the small number of U.S. banks with assets of $20 billion to $350 billion-there are only about 36 of them in an industry of more than 7,000-never intended to be in that bucket. Some, you would suppose, were essentially community banks that had grown too big for their britches, while others were aspiring national players with growth plans (or exit strategies) that had somehow stalled out.

Right? Maybe not. This view would ignore the nuanced realities of banking, some of which have helped define the industry for years, while others are just beginning to surface.

To be sure, many regionals are thriving. In the post-crisis era, they've achieved a Goldilocks compromise on size: not too big and not too small. They are able to handle new compliance burdens more easily than community banks and ward off many of the legal, reputation and regulatory challenges hampering the biggest banks. As Fifth Third CEO Kevin Kabat observes, "No one is talking about breaking us up."

Indeed, it's a good time to be the middle child in this industry as they look for growth opportunities at the expense of their smaller siblings and learn from the bigger's mistakes. The healthiest regionals are poised to be consolidators of smaller banks as the ranks of willing sellers begin to thicken. And while they scour for buying opportunities, they continue to capitalize on the missteps of the national banks that in many ways have failed to live up to efficiency expectations that their bulk was expected to yield, Bernstein Research analyst Kevin St. Pierre says.

"You had decades where the bigger guys could have gotten their act together. They had lower capital ratios and should have been able to price for market share gains, and they really didn't do it. So now we're in a whole new world where the bigger banks are going to be holding more capital, and to earn the same spreads they will have to price down on deposits and price up on loans relative to banks that are going to be running with 50 basis points to 100 basis points less on capital," says St. Pierre.

The banks in the next tier, the midsize to large regionals, have, St. Pierre says, "enough scale to weather the regulatory changes and compliance with the Dodd-Frank Act-it doesn't hit their profitability nearly as much as small banks-and they still have plenty of runway to roll up some of the community banks, as those banks realize it's not just the low-rate environment that's hurting them. It's a good sweet spot."

That conclusion harmonizes with the song that regional bank executives have been singing for some time.

Commercial and industrial lending to businesses with about $200 million to $2 billion in annual sales has been a particularly busy area, Kabat says. "Some of our larger brethren have vacated that spot, and we've been able to fit right in there."

One exception has been retail banking, where regional banks last year lost as many new relationships as they gained, according to data from research firm TNS.

Larger banks may have higher retail attrition rates, but when customers leave, it's usually for another large bank, says Teresa Epperson, a managing director at the consulting firm Alix Partners. But when regionals lose retail customers, about half the time they flock to one of the nationals.

But overall churn in banking remains relatively low. Usually no more than 7% to 8% of consumers switch banks each year, and when it comes to consumer market share, the profitability dynamics in banking are different from other industries, says Joe Hagan, a senior vice president at TNS.

"In the retail industry, if you're Target or Dillard's or Macy's, it's hard to have a good year without also having strong sales. That's not necessarily true in banking, and I think that's an under-appreciated reality," Hagan says. "The truth is, banks, especially in the short run, but even in the middle run, can essentially be doing terribly in terms of the marketplace while improving their profitability."

That's why Kabat says he's more focused now on capital ratios and returns than market share. Given the profit-draining effect of new regulations on many customer relationships, "you can die a slower death growing market share in our business," he says. And that's been no small change at Fifth Third, traditionally a leader in free checking. Kabat says he can't understand any bank that continues to woo customers that way.

It's the economy
No doubt the relative steadiness of the Midwestern economy has helped regionals like BMO Harris and the Ohio trio of Fifth Third, KeyCorp and Huntington Bancshares. FIG Partners analyst Christopher Marinac has a positive view of regionals across the board. Indeed, some regionals like BB&T, which is in 12 states in the Southeast, have thrived in stressed areas of the country. "As I see it, they're all going to be making reasonable returns on equity this year, which is going to be better than what we're going to see at a lot of the community banks," says Marinac. Most of the big regionals will generate ROE of 10.5% to 12%, versus 7% to 8% from most community banks, he says.

Regionals that take advantage of their newfound strengths will be reshaping more than their financial statements. Wayne Busch, managing director in Accenture's North America banking practice, predicts that the industry, which 35 years ago had more than double the players it does today, will shrink by another 1,500 banks through the end of this decade. He says regionals will be part of the consolidation, whether they're gobbling up community banks or forming super-regionals.

Either way, the impetus will not be a growth-at-all-costs approach but more considered thinking about optimizing product sets and exploiting geographic adjacencies, he says.

Even Synovus Financial, which had a long climb back to health and is considered by many analysts to be more of a potential seller than buyer, is looking forward to the day when it revives its acquisitive streak. "Today we're focused on organic growth and fixing our own company," Synovus CEO Kessel Stelling says. "We like to think we will play a part in future consolidation. We think Synovus has been a very good acquirer of companies" over its 125-year history.

For now, Stelling waves off speculation that his Columbus, Ga., company is a takeover target. And despite the ever-present imperative for growth, he doesn't feel pressure to grow the $27 billion-asset Synovus just for the sake of spreading new regulatory and compliance costs across a broader asset base. "We think we fall into that sweet spot of banking where we can absorb the cost. We don't like it, but we can absorb it ... and [still be] more nimble and act more local than many of our larger friends in the industry."

How far in either direction does that sweet spot extend? Stelling laughs, "I joke with my peers about this: Most bankers will say that below a certain asset threshold, there is no way to absorb the new regulatory costs, and the threshold most people pick is the asset level immediately below them."

James Dunne is senior managing principal of Sandler O'Neill & Partners. "You want to be either $9.9 billion or $49 billion," he says, referencing the impact of new regulations, including some that apply only to banks with assets of $50 billion or more and others that carry exemptions for banks under $10 billion. "In general, $3 billion to $9.9 billion is a good place to be, $20 billion to $49 billion is a good place to be, and $100 billion to $300 billion is a good place to be."

Others in the industry agree, as evidenced by recent deals such as FirstMerit Corp.'s purchase of Citizens Republic Bancorp, which boosted Akron, Ohio-based FirstMerit's assets from $14.6 billion-right in the no-man's land, based on Dunne's assessment of the industry-to $24 billion.

Acquisition stand-down?
As a competitor to national brands and community banks alike, regional banks walk a tightrope when it comes to culture and management style.

John B. McCoy, who was CEO of Banc One when it purchased First Chicago NBD in 1998, remembers this issue as the tipping point at which his Columbus, Ohio, company began to model itself more in the image of the largest banks than the local ones.

"When we had 20 presidents in Ohio, I could manage that. When we got up to 50 presidents, it got to be a real issue," McCoy says. "We got to a point after we acquired First Chicago that we really needed to centralize more. There's a size where it gets difficult to make [the local model] work." Banc One eventually was sold to JPMorgan Chase in 2004.

McCoy generally applauds the work being done at today's regional players. Reached at his office in Columbus, he says in that city, Huntington, which is headquartered there, does a good job of replicating a community bank feel that belies its $56 billion asset base.

"It's not black and white," he says of the prospects for regional banks everywhere, "but if I was a Fifth Third or a Huntington, I'd probably like my position. Now, would I rather be Fifth Third or JPMorgan? …I'd like to be either one of them, especially if we can get an upward sloping yield curve. If the economy starts to move, they [both] have good opportunities."

It isn't just JPMorgan Chase that has regional executives looking over their shoulders. As all of the big banks start to wrap up the exercise of jettisoning non-core assets and honing their focus on plain-vanilla banking, competition in markets across the country will increase. Kabat points to Wells Fargo as a prime example of a stirring giant.

"In the past, Wells Fargo was an acquisition machine. But they can't play that game anymore, by law, because of the 10% deposit cap. So...now Wells will focus on the core delivery of value-and maybe they always have, but they also had these other business lines."

And that, Kabat says, "will raise the bar for all of us."

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