5-Step Community Bank Performance Test for Management

Article By: T. Stephen Johnson

The United States has endured 513 bank failures and counting since the beginning of 2008, up from 27 combined bank failures in the eight years prior. While this is an alarming statistic, failures project to be 10-times less this year than they were five years ago, and the amount of problem banks are at a six-year low of 253.

As banks continue to work out of previous constraints, activist shareholders are becoming prevalent, especially in the private equity community. These shareholders are beginning to focus on return on investment, and community bank directors have a responsibility to examine their bank’s performance in the eyes of its investors. 

The following is a 5-step exercise that community bank management and directors should complete which uses key performance indicators to compare a bank’s performance to the industry average.

Step One – Return On Average Equity

ROAE is a measure of a bank’s profitability and can be found by dividing net income by average shareholders’ equity. The median ROAE for community banks was 7.29% in 2014. If your bank is above the average ROAE and continues to have loan growth, use income to support growth. If loan growth is stalled, consider paying or increasing a dividend to shareholders. For those under 7.25%, proceed below. 

Step Two – Fee Income

Fees assessed to customers on account-related activities generate a majority of non-interest income for banks. The mean non-interest income divided by average assets for all community banks in 2014 was 0.56%. The top 50 performing institutions have much higher percentages, which can be attributed to niche market activities. Bank’s searching for higher fee income should consider adding a niche product or service, such as emerging opportunities in SBA lending or payment processing.

Step Three – Net Interest Margin

A bank’s net interest margin is the difference between the interest income generated and the amount of interest paid out relative to the amount of interest-earning assets. The median NIM for all community banks in 2014 was 3.75%, a number that has remained flat over the last few years. The top 50 performers have a median NIM of 4.21%. Finding a niche lending market to serve, such as specific groups of small business professionals, can lead to improved NIM. If the market opportunity is not there for revenue growth, it is probably time to look for a merger partner in need of deposits to meet loan demand.

Step Four – Efficiency Ratio

The efficiency ratio is a measure of the amount of non-interest expense it takes to generate a dollar of revenue. The median efficiency ratio for community banks in 2014 was 52%. By now most banks have cut as much personnel as possible to keep efficiency ratios down, and selling or closing branches may be the next best opportunity if ratios remain high. If loan and deposit growth is stalled, it may be time to look at a new branch strategy. In-market mergers can generally lead to a 33% expense reduction for the new combined entity, and online banking, ACH drafted payments and ATMs make account closings less likely in a branch closure scenario. 

Step Five- Capital Ratio

A capital ratio is the comparison of a bank’s core capital and its total assets. Today, community banks with more than an 8-10% capital ratio are considered overcapitalized and acquirers will not pay a premium on capital that is not deployed. Most bank acquisitions will require targets with more than 10% capital to make a one time special dividend to shareholders before closing. Your bank may want to adopt a one-time dividend program or an ongoing return of cash to shareholders if it is overcapitalized. A stock buyback program is also an option to reduce the number of shares outstanding, therefore increasing earnings per share.

Hopefully this test will have your bank’s managers and directors thinking about new ways to increase shareholder value if the bank is underperforming compared to its peers. Remember, “hope” is not a strategy.


*All industry averages are according to the Capital Performance Group.