Bet on the Small Fry

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With marketing razzmatazz and customer service, small-scale lenders have a big future.

The great sweep of bank consolidation over the past two decades has given rise to some national giants like Wachovia and Bank of America, while leaving behind 1,920 little banks--those with assets under $10 billion. These pip-squeak lenders are not necessarily doomed. The consolidation wave, predicated as it is on closing branches and firing tellers, has left in its wake a certain amount of customer disaffection. This the smaller banks can exploit.

The small banks push customer service, are shrewd at attracting no-interest deposits, and focus on making profitable loans to small businesses, which big lenders ignore.

To attract customers to its Florida turf, Alan B. Levan, BankAtlantic Bancorp's chief executive, sends a dozen Volkswagen bugs, painted in loud colors and bearing the bank logo, out on the road. The employees of the month get to drive them for their personal use for the month. The bank is open seven days a week, and on Fridays it showers patrons with cheap gifts like key chains.

In Florida and Texas, two high-growth states known for setting banking trends nationally, out-of-state banks control around 70% of deposits. Yet this predominance may have peaked. Florida's three largest banks--Bank of America, Wachovia and SunTrust--saw their combined market share fall to 43% at June 30, 2002, from 49% the year before, according to securities firm Stephens Inc. Another Stephens study found that out-of-state Texas banks managed to increase Lone Star deposits by only 1.6% annually from 1997 to 2001 (excluding acquisitions) while bank deposits statewide expanded 5.75%.

You can often get a piece of a smaller bank at a good price. The table opposite shows eight with assets of less than $10 billion. Their profitability, as measured by return on equity, is nothing dazzling, but their growth rates are good and their prices a reasonable multiple of earnings.

For comparison: At the 11 biggest banks (excluding the globe-girdling giants Citigroup and J.P. Morgan Chase) tracked by SNL Financial, a stock research firm in Charlottesville, Va., return on equity averages 16.3% and return on assets, 1.4%. But note that the small banks in the table are expanding earnings at a 12% to 22% clip, compared with an average 4.3% for the SNL 11.

One weak spot in small lenders is their interest margin. This is the spread between what they pay for deposits (excluding the cost of those tellers) and what they charge in loans before deducting for loan losses. BankAtlantic's (assets: $5.8 billion) spread is 3.3 percentage points. The SNL big bank average is 4.4. Small banks, though, tend to be conservative lenders. According to SNL, delinquent loans for small banks with assets less than $10 billion nationwide were at 0.78% of total loans last year, while big banks averaged 1.25%. BankAtlantic's bad loans were 0.54%.

Says Stephens Research Director Brian Bush about small banks: "They know their customers better."

BankAtlantic has something else going for it. It has a high level (41%) of no-interest deposits, compared with an average 27% at big banks, according to Putnam Lovell. At a time when the Federal Reserve is gunning the money supply and keeping overnight rates not far from 1%, those cheap deposits aren't worth a lot. But if short-term rates climb a few points, the cheap money will turn into profits.

The bank issues no residential mortgages and holds a modest 20% of assets in mortgage-backed securities and other bonds, so the asset side of its ledger is not very vulnerable to interest rate swings. Its favorite asset is a short-term construction loan repaid in 18 months and carrying an interest rate a point over prime.

BankAtlantic bought investment bank Gruntal last year to add to brokerage Ryan Beck. Investors cheered its plan to spin off housing developer Levitt.

Small banks spoil customers with friendly service, free checking and all-week banking. In North Carolina acquisitions helped fuel First Bancorp, where loans have grown at double the rate of deposits. It also expanded in South Carolina last year, adding Carolina Community Bancshares for $17 million.