For Small Banks, It's a Wonderful Life

They're gaining on the biggies with old-fashioned service

Michael Berk, chief executive of H&S Yacht Sales in San Diego, has had more bankers than Southern California has sunny days. Each time his bank merged with another, he says, service got worse. "The big joke was if we wanted to find out something about our accounts, it was, `Call the 800 number in Fargo,"' says Berk, whose company sells $60 million in luxury boats a year. Last month, after his big bank changed his contact person for the sixth time in four months, he moved all his business to Beverly Hills (Calif.)-based City National Bank, which has just $10 billion in assets. In four days, Berk got the line of credit he had waited three months for at his old bank. City National reps even call Berk regularly to check in on him.

Small banks are back on the map. A few years ago, they seemed headed for extinction as retail banks consolidated into a few national players, then expanded into everything from insurance to investment banking. Hell-bent on cutting costs, the megabanks closed tens of thousands of branches, raised account minimums, and slapped on ATM fees. It was a big miscalculation. "Retail has been an undervalued business," says Gordon J. Goetzmann, managing vice-president at First Manhattan Consulting Group, which specializes in financial services. "Big banks just don't get it."

Scorned customers have become a ripe market for community banks. At 48-year-old City National, profits and loan growth are outpacing those of giants like Bank of America (BAC ) and Wells Fargo (WFC ). Small banks specialize in the royal treatment. Some serve Starbucks coffee. Others offer free baby-sitting and investment advice. And they all cater to markets that big banks have given short shrift, including small businesses, minorities, and rural areas. "The big guys abandoned small towns where their roots don't run deep, and we've taken the market," says J.W. Davis, president of 15-branch MountainBank Financial Corp. His five-year-old bank is now No. 2 in its home county of Henderson, N.C., after Raleigh-based First Citizens Bank, and ahead of $326 billion Wachovia Corp. (WB )

The battle isn't just for fringe markets. Vernon W. Hill, chairman of Commerce Bancorp Inc. in Cherry Hill, N.J., is moving into New York, home turf of the nation's largest players--Citigroup (C ) and J.P. Morgan Chase (JPM ). Thousands flocked to the opening of Commerce's Midtown Manhattan branch last fall for free sandwiches, shoe shines, and caricatures. Lured by free checking, no minimum balances, extended hours, and even free toasters, customers deposited $1 million in the first week. The bank's assets grew 40%, to $12.5 billion, in the first quarter of 2002, compared with a year ago. This year, it plans to open 40 branches in the Northeast.

The irony is that the little guys are making money doing what their bigger rivals said wasn't profitable. Small-bank profits have grown at 11.8% annually for the past five years, vs. 8.5% for the big players, says analyst Anthony R. Davis at Ryan Beck & Co., a boutique investment bank. "They generate higher returns by taking less risks," he says. And deposits at smaller banks have grown by 5% a year since the mid-1990s, while growth at large banks has been flat, says First Manhattan's Goetzmann.

Investors have sat up and taken notice. The prices of some small-bank stocks are hovering around 52-week highs they hit recently: BSB Bancorp Inc. in Binghamton, N.Y., surged to $32.80 on Apr. 17, and United Commercial Bank, which targets San Francisco's Asian community, jumped to $38.58 on Apr. 12. "Small banks can make money in almost any environment," says John Lyons, president and bank stock portfolio manager for New York's Keefe Managers Inc.

Small banks have been mostly immune to the static economy. Unlike those of the big banks, their customers tend to be local businesses with less exposure to broad economic cycles. Besides, falling interest rates have cut the small banks' cost of funds, boosted their already higher margins, and fueled record mortgage refinancings. Even when interest rates rise, service fees for existing mortgages will continue to feed profits.

Some of the best small banks are thriving because many of their executives once worked at megabanks. They add tight financial management to the small banks' warm-and-fuzzy service. Joseph M. Grant, chairman of upstart Texas Capital Bank, was chief financial officer at Electronic Data Systems and CEO of Texas American Bancshares, the sixth-largest bank holding company in Texas during his tenure in the late 1980s. Others are importing different kinds of expertise. For example, Keefe helped Bay View Capital Corp. in San Mateo, Calif., hire Robert B. Goldstein, a veteran of small-bank turnarounds, as CEO last year. Goldstein has slashed Bay View's bad loans to $83 million from $800 million.

To be sure, small banks aren't just about altruism. "Most bankers who start new banks are building them up to sell," says Keefe's Lyons. "They do it because they expect to make a lot of money." What's more, the small fry aren't all hometown heroes. In January, for instance, regulators closed Miami's Hamilton Bank at a cost of as much as $500 million to the Federal Deposit Insurance Corp. because of bad Latin American loans and concealment of its books from the authorities. Others have taken heat for growing too fast. Sovereign Bank of Wyomissing, Pa., made "one of the riskiest moves in banking history," by going deep into debt to expand, says Keefe's Lyons. Its thinly capitalized holding company borrowed $1.4 billion to buy about 280 branches after the 1999 merger of Fleet Financial Group and BankBoston Corp. "We believed enough in the earnings prospects that we were willing to put on more debt," says Sovereign CFO Mark R. McCollom. Although the balance sheet is improving, some analysts say the bank is still on thin ice.

Big banks have started to notice that the business they once disdained is making money for others. So they're moving back to capture lost terrain. FleetBoston, which only a few years ago was determined to compete with the biggest, is selling its investment bank, Robertson Stephens Inc., and scaling back venture-capital investments to concentrate on retail banking and lending to midsize businesses. J.P. Morgan Chase, meanwhile, forecasts it will soon earn half its profits from retail customers, up from 40% now.

The attention to bread-and-butter customers is the same formula that, along with shrewd acquisitions, propelled Seattle's tiny Washington Mutual Inc. to a $275 billion national bank in a decade. Khaki-clad tellers still roam the floor asking customers what they need. The answer, obviously, has been more TLC, and less ATM.

By Mara Der Hovanesian and Heather Timmons in New York, with Chris Palmeri in Los Angeles

— With assistance by Christopher Palmeri

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