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Connecticut's community banks have held up relatively well during the economic downturn of the past few years with no bank failures and only a spat of merger activity.

But while economic conditions are improving, community banks are still facing huge challenges, with questions arising about whether they can survive a changing environment that seems to cater to larger financial institutions.

Whether it's the prolonged low interest rate environment or new compliance costs associated with financial regulatory reform, community banks, particularly those with less than $1 billion in assets are feeling the squeeze.

But industry officials say they remain hopeful, even optimistic, that they can adapt. It may, however, require changes to how they do business, including re-pricing products, growing larger to gain more scale, partnering with other banks or diversifying their business lines.

"The competitive landscape has changed," said Martin Geitz, president and CEO of Simsbury Bank & Trust, which has five branches in the Farmington Valley and $351 million in assets.

Geitz said the biggest challenge for small lenders right now is the low interest rate environment. The Federal Reserve's announcement last month to extend low rates through at least 2014, makes it a long-term worry.

Geitz noted that about 80 to 90 percent of a community bank's operating revenue typically comes from its net interest margin, which is the difference between the money a bank gains from interest on loans and the money it pays out as interest on deposits.

With interest rates at nominal levels, that margin gets squeezed pushing down bank earnings. Larger financial institutions can cope better, Geitz said, because they rely more on other revenue sources giving them a competitive edge.

"Small banks don't have fee income that larger banks have," Geitz said.

That could force community lenders into difficult decisions on the pricing of their products. While many large banks have already added new fees to make up for lost revenue in recent years, community banks have maintained free checking and debit card services and have used that as a key marketing tool to distinguish themselves from larger competitors.

"More community banks are looking at whether that pricing decision is sustainable," Geitz said. "For the last 15 years, community banks led the way being fee-friendly, while big banks were feeing people to death. It was a real market differentiator. We as an industry have trained people to expect those enhancements at no cost. But the reality is it does cost money."

To be sure Connecticut's community banks have mostly withstood the test time of time throughout the economic doldrums of the last three-plus years. There have been no bank failures in Connecticut and merger and acquisition activity has been slow.

The state's 42 banks with less than $1 billion in assets collectively earned $28.8 million in profits through the first three quarters of 2011, up significantly from the same time period in 2008, when those same banks posted a $24 million loss.

Improving investment gains and credit quality among borrowers has helped their bottom lines recover from the depths of the financial crisis. But those banks are once again coming under earnings pressure. The $28.8 million in profits is actually down 1 percent from a year earlier, even though economic conditions have arguably improved since that time.

Total interest income is down 5 percent from a year ago. Meanwhile, those banks saw a nearly 10 percent increase in personnel expenses, the highest percentage jump in that area over the past four years. The increased expense is likely being influenced, in part, by tighter compliance standards banks are being forced to comply with as a result of financial regulatory reform.

At Thomaston Savings Bank, for example, the compliance department has grown from one full-time staffer a few years ago to two-and-half people. The $681.6 million bank is also spending more money on outside consultants as well as experiencing hidden costs associated with retraining and changing business processes.

Stephen Lewis, CEO and president of Thomaston Savings Bank, said regulators are being are much more thorough in their examinations and have raised the level of expectations with respect to compliance. And many of the new regulations from the Dodd-Frank financial reform law have yet to be interpreted and implemented, leaving long-term uncertainty on what it might cost banks to comply.

"The regulatory front is difficult right now," Lewis said. "It definitely hurts efficiency."

Connecticut Banking Commissioner Howard Pitkin has raised red flags that the impact of the Dodd-Frank financial reform law could threaten the viability of community lenders. Pitkin said compliance exams are becoming increasingly expensive for small lenders, which is putting their earnings under significant stress.

"They can't afford a large compliance staff the way regional or national banks can," Pitkin said. "The more resources they devote to that, the less they can devote to loan officers."

Pitkin said there will likely be some consolidation among community banks, but he doesn't think community banks will go away entirely in Connecticut.

"Community banks will have to be very lean, but also grow to a point where they can withstand the competitive pressures around them," he said.

Christopher Maher, CEO of Stamford's Patriot National Bancorp, said that could mean community banks will have to move upstream, making the smallest of lenders, those with a few hundred million dollars in assets, an extinct species in the coming years.

"Many community banks will have to increase in size to spread expenses over a larger asset base," Maher said. "In the next three-to-five years, the average community bank is going to be bigger."

So far, M&A activity for community banks in Connecticut has been slow in recent years, despite predictions by some industry experts that deal flow could be substantial. Hartford's Connecticut Bank & Trust, with $280.5 million in assets, was the most recent bank to decide that partnering with a larger institution was the best path. The bank agreed to be acquired by Berkshire Hills Bancorp of Massachusetts in a cash-and-stock deal valued at $30 million. CBT, which reported a $2.6 million loss in the fourth quarter, has struggled with losses in its loan portfolio.

Beyond that deal, 2011 was mostly quiet on the M&A front, although several larger community banks did go public raising tens of millions of dollars in cash, pushing them above the $1 billion in asset mark. It could put those lenders — including Rockville Financial, Farmington Bank, and SI Financial Group — in a position to acquire a smaller bank in the coming months or years. Also, by going public, those larger community banks have agreed not to be acquired for the next few years.

While challenges remain significant, community bankers still are optimistic that they can compete. Indeed some small lenders have been able to grow their market share in recent years, although the big national and regional banks in Connecticut still overwhelmingly dominate the market. Banks are also adding new branches and diversifying or expanding business lines to try to search for top line growth.

Simsbury Bank, for example, has expanded its mortgage product line to include FHA and jumbo loans, hired two more mortgage originators and plans to add up to five more bankers in the next few months.

Thomaston Savings Bank is opening a new branch is Bristol giving the lender its first brick and mortar presence in that city.

Maher said Patriot National has been shifting away from residential construction lending and reallocating bankers to focus on consumer and commercial real estate and industrial loans.

"I don't believe that community banks will become extinct," Maher said. "They add too much value with their knowledge and understanding of local conditions."

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