The Evolution of the Community Bank Business Model Series: Impact of Technology*
The Evolution of the Community Bank Business Model series kicks off with this article on the opportunities and unique challenges the evolving technology landscape presents to community bank innovation, competition, and achieving scale. This article also provides an update on regulators’ actions to support community bank innovation.
The financial sector has historically embraced technological advances with varying degrees of enthusiasm and some pragmatism. Since the first automated teller machine was introduced more than 50 years ago, the industry has witnessed a shift to IT-based delivery systems, automated payment clearing, and internet banking as well as a proliferation of new financial products.1, 2 Emerging technologies (e.g., machine learning, natural language processing, cloud computing, robotic process automation, faster payments, and application program interfaces) continue to transform the banking industry and are increasingly important to how banks innovate and keep pace with competition in the industry from financial technology (fintech) firms, credit unions, and their peers.
Banks both large and small recognize the importance of technology investment. A 2018 Florida International University study showed that the median real technology spending per bank has doubled since 2000 for both small and large banks.3 However, for similar proportional investment, this study noted that the payoff from technology investment differed, with large banks seeing a greater increase in operational efficiency, profit margins, and market value. The study noted that smaller banks still needed to adopt new technologies to remain competitive in the market.
Respondents (64 percent) of the Conference of State Bank Supervisors (CSBS) 2020 National Survey of Community Banks4 viewed banks’ adoption of new technologies as a necessity in delivering their products and services. However, a community bank’s ability to adopt new technologies and innovate is dependent on its customers, its ability to acquire and develop staff expertise, and partnerships with its core service provider (CSP), fintech firms, and other vendors.
Community banks tend to demonstrate strength during times of crisis and uncertainty in part due to the strength of their relationships with customers, and they can leverage their experiences during these times to build for the long term in order to maintain or increase market share. Prior to the pandemic, community banks were losing ground to larger banks and nonbanks as customers sought faster access and a wider variety of lending and deposit options. For instance, over the past few years, community banks had been losing ground to bigger banks in small denomination business loans, a product commoditized by larger banks given that these loans do not require “soft” information about borrowers for approval.5 Additionally, larger banks, which have deeper pockets and more technological strength, have taken advantage in gathering deposits through online channels that collect internet deposits.
Competition from nonbanks is increasingly another concern, as smaller banks are disproportionately affected by health savings accounts, peer-to-peer payments, automated investment platforms, and customer loyalty credit cards. Underscoring the competition from nonbanks is the re-emergence of industrial loan company charters and the creation of other related regulatory structures. In addition, credit unions have purchased an increasing number of community banks in the past decade. Additionally, due to a variety of factors, the number of community banks nationwide has declined by nearly 50 percent in the past two decades, going from 9,795 at the end of 2000 to 5,036 at the end 2019.6
At the beginning of the COVID-19 pandemic, there was a great deal of uncertainty as to how banks should adapt their operations in order to continue to serve their customers and communities. Despite the challenges of the pandemic, community banks shone a bright light on the importance of the relationship banking model as they successfully supported retail and small business customers. As community banks were compelled to temporarily close branches to keep customers and staff safe, technological interfaces that were already available but not used by large segments of customers were leveraged to great success. Further, community banks administered about 40 percent of the loans (by loan amount) in the 2020 Small Business Administration Paycheck Protection Program, which far exceeded their 15 percent representation in the banking industry by asset size.7
As the pandemic experience demonstrated, community banks can compete by designing their delivery of key banking products and services to meet ever-changing customer preferences, while maintaining essential elements of relationship-based lending.
Community banks are challenged with serving a wide array of customers with varying needs. Many community banks are located in rural areas and serve an aging demographic, while younger potential customers migrate to larger cities for employment opportunities.8 This challenge represents potential opportunities for community banks to build multiple channels, both physical and online, to deliver products to customers in their geographic markets and to expand into other markets.
Additionally, in the midst of the pandemic, through necessity, banks were able to reintroduce technology tools that were not heavily marketed in the past to customers who were hesitant to use them. Community banks could benefit from leveraging the momentum created by the pandemic to explore technologies to increase product and service offerings. This would not only benefit current customers but also serve to broaden the geographic and demographic reach of community banks and to gain new customers.
Talent Resource and Knowledge
While this may be an opportune time to encourage once-resistant customers to use more technologically advanced products and services, a bank’s board of directors, senior management, and staff will also have to be adaptive to technological advances and associated risks. For instance, as banking services are made more available online, the risk of cyberattacks increases. Over the past few years, there has been a rise in reported cybersecurity incidents, such as the recent Finastra, SolarWinds, and Microsoft Exchange breaches. Given their geographic location, limited cybersecurity talent, and fierce competition for cybersecurity professionals driving up wages, community banks are challenged to hire or develop this necessary talent.
Another key risk continues to be managing third- and fourth-party vendor risks as banks leverage technologies to innovate and remain competitive. It will be important for a bank’s board of directors and senior management to have a more nuanced understanding of technology services to ensure that they understand how their bank can continue to operate in a safe and sound manner. The bank’s board of directors and senior management should understand who is responsible for which elements of the technology purchased from a provider (e.g., who owns the data, who is responsible for data protection, who has access to the data, and how the data can be used) to mitigate exposure to residual risks. In considering various technologies and business partners, a bank will need to understand its exit strategy, data privacy security requirements, contingency plans, and data retention policies. These risk factors also have implications for a bank’s needs for talent and expertise among its board of directors, senior management, and staff.
Respondents to the 2020 CSBS survey expressed concern about the complexity of technological advances compared to the expertise of bank staff. Talent acquisition can be a challenge because community banks typically hire from their local communities and their geographic locations often make it difficult to access or attract talent with deep technological expertise. Additionally, community banks may not be able to compete with the compensation or training programs offered at larger banks.
While these challenges are daunting, the evolving conversation about the future of work and changing priorities toward work–life balance may present unique opportunities that community banks can leverage. In thinking about these issues, community banks should consider evolving their human capital strategies to address the challenge of hiring staff with the requisite technical skills.
Core Service Providers (CSPs)
Perhaps the biggest challenge to innovation is a community bank’s access to technology services that are aligned with its strategic plan and budget. Given their size and resources, most community banks source their technology platforms from CSPs. Therefore, community banks tend to be reliant on CSPs’ abilities to innovate and provide scale, though there is a limited number of CSPs from which to choose.
CSPs tend to invest in product development either through mergers and acquisitions of fintech firms or through research and development; however, it is difficult to measure the pace of their innovation in comparison to the broader financial services industry. Although community banks are generally satisfied with the basic services (e.g., risk management, security) of their CSPs, according to the CSBS survey, they are interested in innovation through expanded product offerings to achieve efficiency and scale. This increases the opportunities for new partnerships between fintech firms and community banks because fintechs are providing new ways for community banks to innovate and compete (from automated mortgage and auto loan origination to anti-money laundering transaction monitoring). A community bank’s ability to partner with these firms and take advantage of these new technologies, however, is sometimes dependent on its CSP’s openness to third-party providers and scalability of the core platform.
Therefore, it is important for community bank leadership to have a good understanding of its CSP’s technical capability and the details of contractual obligations, especially when considering terminating the relationship with a CSP or entering into a partnership with a fintech firm. Service contracts with CSPs can include legal and financial barriers for early termination, and there are high operational costs to migrating to new platforms. According to the 2020 CSBS survey, 47 percent of the respondents were dissatisfied or highly dissatisfied with the flexibility offered by their CSPs, 40 percent of the respondents were dissatisfied or highly dissatisfied with the cost of their core processing services, and 40 percent were dissatisfied or highly dissatisfied with the speed of innovation at their CSP. In addition, the use of an open application program interface (API) to facilitate fintech firms’ connection with CSP systems is key for community banks when engaging with fintech firms. While APIs are not new and come with challenges, including security threats, system compatibility, and expertise requirements, their increasing usage and importance makes them transformational and an important factor in the discussion between a community bank and its CSP.
With the proliferation of technology, community banks may need to assess the products and services offered by their CSPs. Therefore, banks will need to actively manage the relationship to ensure their CSPs deliver a robust suite of technologically advanced products and services, either directly or indirectly, through connections to third-party vendors and fintech firms. With more to gain, community banks could use their collective voice to demand more from their technology partners, particularly CSPs.
There is a cost element associated with innovation; community banks and CSPs will have to weigh the costs and benefits of innovation to reach acceptable solutions for both parties.
A Comprehensive Business Strategy
A comprehensive business strategy that articulates a clear case for new or existing products and services based on client needs and growth opportunities is important for community banks. Such a strategy would help them compete in a changing landscape and address the challenges discussed in this article.
The business strategy can:
- position a bank to achieve the agility required to support existing and new customers both inside and outside of the bank’s immediate geographic location.
- organize a bank to use the momentum coming out of the pandemic to help customers get comfortable with using more advanced technologies.
- provide a risk management framework (that includes managing technology and cyber risks, third- and fourth-party vendor risks, and risks related to product specializations) to ensure that bank staff and management teams are prepared to operate in this new and rapidly changing environment.
- prepare a bank for attracting and retaining clients as well as acquiring and retaining talent. This includes expanding its human capital strategy to ensure that bank staff have necessary technical skills and expertise through training or hiring.
- help a bank actively manage its relationships with third-party service providers, including its CSP. Community banks should ensure that CSPs are not limiting their technological innovation.
Regulators are committed to engaging with community banks and providing resources to support the innovation of community banks as they navigate the challenges of the evolving banking environment. The following are a few Federal Reserve System and interagency initiatives:
- Innovation Office Hours — In 2020, the Federal Reserve began hosting these sessions to facilitate face-to-face discussions on innovation in the financial services with supervised financial institutions, fintech firms, Federal Reserve staff, and other industry participants. Innovation Office Hours can be two-way learning opportunities for both the firms and Federal Reserve staff. Sessions were held in June and September of 2021, with more to be scheduled in 2022. Community banks are encouraged to attend the sessions hosted in their District. For more information, refer to the Innovation page on the Federal Reserve Board’s website.9
- Fintech Partnership Staff Paper — As Governor Michelle W. Bowman referenced in the first issue of 2021 of Community Banking Connections, Federal Reserve Board staff held discussions with community banks, technology companies, and other relevant stakeholders to gather their perspectives on the evolving landscape of community bank partnerships with fintech firms. Board staff distilled key insights in a public paper to serve as a resource to community banks considering fintech partnerships. To access this resource, refer to the Board of Governors’ website.10
- Community Bank and Service Provider Series — In September 2021, the Federal Reserve System hosted the first session in the series to help community banks build a stronger understanding of the value and risks associated with fintech firms and their intersection with CSPs. This session was a mechanism to help community banks build their collective voice when engaging with service providers. Refer to the Ask the Fed website.11
- Conducting Due Diligence on Fintech Firms: A Guide for Community Banks — The Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation recently issued an interagency due diligence optional guide to serve as a resource to community banks as they conduct due diligence on potential fintech partners. The guide is intended to serve as a starting point in the due diligence process and is not intended to create new regulatory expectations. To access this resource, refer to the Board of Governors’ Supervision and Regulation Letters page.12
As the U.S. banking industry has evolved, community banks have largely managed to retain their distinctive attributes and remain an enduring feature of the broader financial system. Still, they are not immune to the intense competitive forces of the 21st century. It is up to community banks to understand these challenges and opportunities to ensure they are appropriately responsive and adaptive.
The second article in this series will discuss the challenges of rural banks in comparison to their urban counterparts with a focus on operational differences between the cohorts.
* This article is the first of a two-part series based on research conducted in 2019 by Federal Reserve staff: Bettyann Griffith, Federal Reserve Bank of New York; Deeona Deoki, Federal Reserve Bank of New York; Chris Henderson, Federal Reserve Bank of Philadelphia; Chantel Gerardo, Federal Reserve Bank of Philadelphia; James Fuchs, Federal Reserve Bank of St. Louis; Mark Medeiros, Federal Reserve Bank of Atlanta; Justin Reuter, Federal Reserve Bank of Kansas City; Jonathan Rono, Board of Governors; and James Wilkinson, retired from the Federal Reserve Bank of Kansas City.
- 1 See Elizabeth Judd, “Timeline: 180 Years of Banking Technology,” Independent Banker, October 31, 2017, available at https://independentbanker.org/2017/10/timeline-180-years-of-banking-technology.
- 2 See Allen N. Berger, “The Economic Effects of Technological Progress: Evidence from the Banking Industry,” Journal of Money, Credit and Banking, 35(2) (April 2003), pp. 141–176, available at www.jstor.org/stable/3649852.
- 3 Zifeng Feng and Zhongua Wu, “Technology Investment, Firm Performance and Market Value: Evidence from Banks,” 2018, available at www.communitybanking.org/~/media/files/communitybanking/2018 papers/session3_paper4_feng.pdf.
- 4 Results of the survey were presented at the 2020 Community Banking in the 21st Century research and policy conference. See www.csbs.org/system/files/2020-09/cb21publication_2020.pdf.
- 5 Data obtained from Reports of Condition and Income (Call Reports).
- 6 Data obtained from S&P Global Market Intelligence.
- 7 Data obtained from S&P Global Market Intelligence.
- 8 Data from the 2010 Census highlight the unique demographic of rural communities. The results of the 2020 Census were not available at the time of the writing of this article to assess changes in the demographics from 2010.
- 9 The Innovation page is available at www.federalreserve.gov/aboutthefed/innovation-office-hours-series.htm.
- 10 See www.federalreserve.gov/newsevents/pressreleases/bcreg20210909a.htm.
- 11 The website is available at https://bsr.stlouisfed.org/askthefed.
- 12 See www.federalreserve.gov/a/srletters/srletters.htm.