Report: Community banks set for a strong year

Community bank earnings will remain strong this year amid a drop in inflation and “measured economic growth,” according to a report from financial services firm Morningstar..Two percent GDP growth is projected this year, which Morningstar expects will support loan demand. As of the third quarter of last year, annualized loan growth was 5.2 percent. The report outlined several risks to the sector, including a potential economic slowdown, interest rate volatility caused by geopolitical conflicts, and additional stress in the commercial real estate sector. Also, operating expenses tied to compliance, cybersecurity and technology are projected to remain higher-than-normal.Despite fintechs having a rising share of consumer and small business lending and deposits, that challenge is limited by community banks’ improved liquidity, healthy capital levels and strong customer relationships, according to Morningstar. “We view the sector as well-positioned to absorb any economic or credit shocks,” according to the Jan. 14 report. “Moreover, these institutions will continue to function as vital engines of the local economy, despite broader industry consolidation trends.” Community banks are operating with average leverage capital ratios at 11 percent and Tier 1 risk-based capital ratios higher than 14 percent, which the report said provides significant protection against credit stress and economic uncertainty. Net interest margins are expected to remain higher than the industry average this year as net interest income is projected to more than make up for moderate rises in non-interest expenses tied to technology and compliance costs. “Banks will continue prioritizing relationship-based lending over balance-sheet expansion, which should support earnings durability and limit incremental credit risk,” according to the report. Unrealized securities losses have fallen as interest rate volatility fell, according to the report, making balance sheets more flexible. Morningstar predicts greater stability will enable community banks to redeploy deposit flows into lending at higher margins and spark NIM expansion. The report also outlined the improved regulatory outlook for 2026 during the second year of the Trump administration. A bill introduced earlier this month would institute a three-year phase-in for de novo banks to meet federal capital requirements. During that time, the Community Bank Leverage Ratio would drop to 7.5 percent or the generally applicable ratio, whichever is lower. The CBLR has seen relatively limited adoption among community banks, with only 41 percent opting in. “Reforms are likely to introduce greater flexibility so the CBLR better aligns with community bank risk profiles,” according to the Morningstar report. “Even if these risks materialize, we expect strong capital levels and loan loss reserves to provide sufficient cushion to navigate these stresses.” Morningstar expects community bank consolidation will continue as banks look to build scale to invest in technology. The number of community banks fell 3.1 percent in the third quarter of last year on an annualized basis to 3,953, with 81 banks merging or consolidating during the first nine months of last year.