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Cathie Rowand | The Journal Gazette
Teller Lori Housden works at the Illinois Road branch of iAB Financial Bank, which was created last year when Grabill Bank and MarkleBank merged. Staying independent is growing tougher for small banks.

Heat's on at the bank

Growth in costs, mergers challenge small institutions

Samuel Hoffman | The Journal Gazette
Tower Bank, headquartered downtown in the Lincoln Tower at left since 1999, will be sold to Old National Bank.
Cathie Rowand | The Journal Gazette
Teller Ashley Johnson works at the Illinois Road branch of iAB. The bank's president and CEO, Mike Marhenke, says mergers cut costs, and he doubts small banks can remain independent.

Mergers and acquisitions – or M&A – activity is heating up as the banking industry responds to impending increases in regulatory costs and ongoing tight profit margins.

Last week, Old National Bancorp announced its $100 million-plus plans to acquire Tower Financial Corp., a deal that didn't raise many eyebrows among those in the industry.

Mike Cahill, Tower's president and CEO, cited regulations and margins as reasons why Tower's board entered negotiations.

Bankers will be asked to navigate new rules issued by the Consumer Financial Protection Bureau and regulations related to the Dodd-Frank Act, which established government agencies to monitor lending and mortgage practices.

The question is: As more federal regulations go into effect in 2014 and 2015 and the economy continues to slog along at an underwhelming pace, can the region's smaller banks afford to remain independent?

Getting bigger

Mike Marhenke believes the answer is no.

The president and CEO of iAB Financial Bank has made no secret of his Fort Wayne-based company's desire to acquire smaller banks to gain economies of scale.

Two banks need two presidents, two human resources departments, two payroll operations, two IT staffs and so on. Merging the organizations typically cuts jobs – which cuts payroll costs. That makes the overall operation more profitable.

Independent Alliance Banks Inc., iAB's parent company, was formed in 2005 as the holding company for Grabill Bank and MarkleBank. The former rivals officially merged last year to form iAB, which has $950 million in assets.

Marhenke thinks that's big enough to survive the banking industry's upcoming wave of consolidations.

The CEO expects more M&A activity over the next 18 months because of increasing compliance costs that will hit at the same time that banks are making less money from fees paid by homeowners to refinance mortgage loans.

Smaller banks will struggle, and larger ones, Marhenke said, will find opportunities for acquisitions.

"These are exciting times," he said.

Takeover fever continues at Old National, even though the Evansville-based bank's acquisition of Tower will boost its asset level up against the $10 billion mark, which triggers additional regulations that cost a company an estimated $8 million to $12 million a year.

Bob Jones, president and CEO, said Old National has a strategy for staying under $10 billion next year, when the Tower deal is expected to close. The plan calls for selling some investments and residential mortgages.

But that's not a long-term strategy. Kathy Schoettlin, Old National's executive vice president and chief of community relations, said the company is still interested in making acquisitions. Jones estimated that Old National will have to grow to $12 billion to $13 billion in assets to make breaking the barrier worthwhile.

"So, obviously, our charge is to get to that size," he said last week in a call with analysts.

More deals expected

Ross Demmerle follows the banking industry, including Tower Bank. The Louisville, Ky.-based research analyst works for J.J.B. Hilliard W.L. Lyons LLC. Several trends stand out in his assessment of the banking landscape.

Banks' asset quality, in general, is improving as the economy slowly improves. The amount of bad loans on the books has been decreasing every quarter. That means banks can put aside less in loan loss provisions, which increases earnings.

The economic recovery will also drive up interest rates, which will increase revenue, he said. Some loans on the books have adjustable interest rates. Banks collect more when the prime rate goes up.

As bigger banks make more money, they'll be in the market for more deals, Demmerle said. And smaller banks' asset quality will continue to improve, making them more attractive.

More deals would have been struck in recent months if sellers' expectations of what their banks were worth were more in line with prospective buyers' assessments, Demmerle said.

The analyst also thinks some potential buyers have been waiting to see whether some struggling banks have their charters revoked. The acquiring banks could get a much better deal on a bank that has failed because the FDIC covers 80 percent of loan losses.

Overall, he said, M&A activity will increase as the health of the banking industry increases.

Magic number

Demmerle isn't sure you can put a dollar amount on how few assets a bank can have and still remain independent.

He's asked many industry players that question and received vague answers.

The research analyst thinks the number is at least $500 million, but some sources have told him $1 billion is more realistic.

Marhenke, of iAB, agreed that it's tough to pick a magic amount of assets. He thinks maintaining sustained growth is key to viability.

Is iAB big enough to survive?

"We think so," he said.

Jim Marcuccilli, Star Bank's president and CEO, said his Fort Wayne-based bank's $1.7 billion in assets puts it in solid shape.

"We think we have more than enough critical mass" to remain independent, he said. "We plan on staying in the market and staying independent."

"The smaller institutions are going to have a tougher time" because of the added costs of complying with increasing regulations, he said.

Michael Zahn is president and CEO of one of the smaller banks in the region. Northeast Indiana Bancorp Inc., the Huntington-based parent company of First Federal Savings Bank, has about $275 million in assets.

Zahn doesn't think an asset amount determines whether a bank will survive. The more important factor, he said, is how the bank is managed. A bank with $100 million in assets could be big enough to survive while one with $1 billion in assets could struggle if it's not well-run.

"For us," he said, "we think $275 million is big enough to continue as a community bank going forward."

Staying smaller

Zahn sees a solid future for First Federal.

"I think there is definitely a need and a place for community banks," he said.

Compliance costs are just something banks need to manage, he said.

"The rules and regulations are what they are, and we don't have a choice of whether or not we meet them," Zahn said. "With a smaller staff, we have a lot of people wearing multiple hats."

Also, bank officials hire consultants to guide them on some issues, he said. They don't expect to have all the necessary expertise in-house.

Last year, First Federal Savings converted from a federal thrift charter to an Indiana commercial bank charter. Bank officials decided to make the change because federal thrift rules require a certain minimum of total assets be used for residential mortgages and no more than 20 percent of total loans be made to business borrowers. The bank wanted to increase its commercial lending portfolio.

That change didn't ease the amount of regulations the bank has to comply with, Zahn said.

The CEO expects to survive as a community bank by providing outstanding customer service and managing overhead.

As the head of a publicly traded company, Zahn isn't allowed to say whether he's been approached by larger banks looking for acquisitions. But if he's approached, Zahn said, his fiduciary responsibility to shareholders would require him to have those conversations.

Who will survive?

Demmerle isn't optimistic about smaller banks going it alone.

"The short answer is: No, they can't remain independent," he said.

The caveat, he said, is for banks that are privately held by investors who are willing to accept a lower rate of return on their money than they could get by investing it elsewhere.

Kenneth Carow, finance professor at the Kelley School of Business on the IUPUI campus, believes a number of small banks will be able to remain independent. But it won't be easy.

Among the challenges, he said, are security demands. Technology has to be constantly updated, but smaller banks don't get the economies of scale that larger banks have, he said. The costs of keeping online banking systems secure, for example, are ongoing because threats continue to evolve.

Diversification is also a challenge, because banks with just a few branches can't diversify geographically, Carow said. That's a disadvantage because sometimes an area is hit hard when a major employer closes, affecting many of the bank's customers.

Instead, small banks need to reduce risk by keeping their loan portfolios diversified, he said. That means lending to various types of borrowers: agriculture, manufacturing, restaurants, homeowners and car buyers.

Despite the pressures, community banks do well in small towns, Carow said, because the bankers develop personal relationships with local business owners and residents.

"Banking," he said, "is still a people business."