Size does matter, if you are a bank.  Big banks enjoy the comfort of a government too scared to let them face the consequences of their decisions, and a federal reserve eager to shore up their balance sheets.  

This isn't a screed against the bailouts.  While I think they just kicked the can down the road — at the cost of future generations –others have made the case more eloquently than I can.

Instead, I want to look at how different the environment is for the small banks.  As a result of the big bank bailouts, all banks face substantially higher FDIC fees.  But they also face a capital and regulatory environment that is worse than the big banks.  As a recent post on the Bank Lawyer's Blog explained:

Here’s the problem facing community banks:  they’re being force-fed a capital starvation diet; and, many of the community banks will die as a result if a solution isn’t found quickly. As best I can tell, there’s little “interest focusing,” but there’s a whole lot of “positioning,” going on in Washington – and that ain’t solving the problem.

It’s bad enough that the banks are suffering malnutrition under the burden of troubled commercial real estate (CRE) loan portfolios.  But, to make matters worse, “tales from the crypt” describe regulatory exams now being conducted from a newly staked-out “position” of “I need to prove I’m the toughest regulatory SOB on the block.”  The result is an almost Sherman-like march through local communities that is wiping out community banks’ capital based on the marking-to-market of illiquid CRE collateral.  Assumptions made in valuing any asset are critical and inherently are subject to human bias; and, overly conservative assumptions that may be used in these exams that shorten the time periods for loss history used as a guide and that also forecast an overly bleak future can make bank death seem pre-ordained – or at least a self-fulfilling prophecy – when current loss recognition is required.

I've heard the same story from nearly every banker I know.  Regulators who were asleep at the wheel when it mattered are now micromanaging lending activity.  Yet, even in this nightmare environment, many community bank stocks are thriving.  Over the last 6 months, the Community Bank ETF (Nasdaq:QABA) is not only up almost 8%, but it has outperformed the broad financial ETF (XLF).

It appears that the tough conditions are working just as Schumpeter would have predicted, fostering "creative destruction" that thins out the weaker banks, and opens the door for better-positioned community banks to grow both organically and by acquisition.  

Over the next few months I will be investigating this group more closely.  These are not sexy tech stocks, but I suspect that the winners in this group will produce mammoth gains over the next five years.  

DISCLOSURE: no position.

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