WORD ON THE STREET: Over the past several months, my fellow state regulators and I have heard the very loud concerns of community bankers regarding their future. These concerns come from the feared trickle-down effect of the Dodd-Frank Wall Street Reform and Consumer Protection Act and other regulatory actions deemed necessary to address identified weaknesses in the banking system. This will undoubtedly add to the compliance burden being shouldered by the industry.
While consumer compliance is significant, in this context, compliance also includes bank secrecy, corporate governance, accounting rules and reporting requirements. In addition, community banks are facing an uncertain future as the structure and role of larger institutions in the economy is evolving and the future of mortgage finance is being debated.
We believe these concerns are very real and are worthy of our collective attention. This should be a serious, national concern. In our view, the viability of the community bank model has significant systemic consequences, which – if left unaddressed – will cause irreparable harm to local economies and erode critical underpinnings of the broader economy.
The challenges the community banking system is facing are already having an impact upon local economic development, as some local economies remain stalled, or even eroded, by more limited credit availability. As you meet with bankers in your office and in your state, I encourage you to ask them about the loans that are not being made.
While some banks are not positioned to lend due to their financial condition, many banks are not making residential real estate loans due to the increased compliance burden. In addition, commercial real estate (CRE) loans are not being made due to the stigma of an entire asset class. We cannot accept this as collateral damage in the interest of consistency and national policy.
Just as small businesses are recognized as critical to the health of our national economy, the U.S. banking system remains the most important supplier of credit to small businesses in the country. While the volumes are large, banks with over $50 billion in assets allocate only 24% of their loan portfolios to small business loans. Banks with less than $10 billion in assets invest 48% of their loans in small business.
There is a very significant difference in the type of small business lending conducted by the smaller banks. In general, the lack of extensive financial data for smaller firms makes it more difficult for lenders to ascertain if a small business is ‘creditworthy.’ This makes community banks particularly well suited for small business lending. The largest banks tend to rely on transactional banking, in which hard, quantifiable information drives performance and products are highly standardized.
Community banks, however, engage in relationship banking, involving the use of soft information that is not readily available or quantifiable. Synthesis of soft information requires more human input, usually acquired by direct exchanges between the lender and the borrower, and relies on lenders empowered with decision-making authority.
Maintaining the availability of credit
These types of loans are economically significant at the local level, providing jobs and economic activity. Collectively, they are significant for the national economy as well.
In addition to providing critical financial support to small businesses, community banks have also proven to be a reliable source of credit for individuals in smaller communities. The nation's largest institutions have a tremendous presence in metropolitan areas but may not provide services to residents of small or rural areas.
Community banks, with their geographically focused service areas, provide the necessary financial products and access to credit for residents of rural and smaller communities. While community banks are essential to the very existence of some communities, I would highlight that the value of the relationship-lending model provides needed services and credit to businesses and consumers in communities of all sizes.
Through strong and weak economic conditions and in times of crisis, community banks provide much-needed stability to the financial system by continuing to make credit and financial services available to individuals and small businesses. For example, during the crisis in the capital markets, the nation's largest banks all but ceased lending activity to preserve capital to remain solvent. Community banks, however, continued to make credit available to individuals and businesses and helped prevent a complete collapse of the U.S. economy.
The past few decades, however, have been marked by a decrease in the total number of insured financial institutions and stunning consolidation of the industry's assets into the largest institutions. In the last 25 years, we have lost 12,362 banks. This represents 62% of the total as of Dec. 31, 1985.
While a significant portion of consolidation may be market driven, we do not believe all of the drivers and long-term impact of consolidation are fully understood. As the industry consolidates, the system is increasingly dominated by the largest institutions. In the last 10 years, the top five banks have increased their market share from 24% to 42% of total assets. This industry consolidation raises concerns because of the critical role many smaller institutions play in the communities and states in which they operate.
To ensure a diverse industry, the community banking system must be able to thrive alongside of, and compete with, other banks, regardless of size. A generally agreed upon – but rapidly approaching – outdated definition of a community bank is an insured depository institution with $1 billion or less in assets. Perhaps a better definition would be an institution with a local focus and scope of activities, with the corresponding experience and expertise to excel at relationship lending. A community bank is to a local business what Wall Street is to a Fortune 50 company: not just a lender, but a financial and business adviser.
Problems with the Dodd-Frank Act
Increasingly, I am hearing a desire from community bankers to merge or sell their institution because they are overwhelmed by regulatory burden and the perception of a federal system that no longer supports their business model. The model of other concentrated banking systems, like Japan, where collapse was followed by long-term stagnation, should be better understood before we continue down the perhaps irreversible road of further consolidation.
The Dodd-Frank Act was a sweeping overhaul of financial regulation and will require significant commitment, time and resources to fully implement. As a result, we are still unaware of the full scope of the impact Dodd-Frank will have upon the industry as a whole, and community banks specifically.
For example, we share our federal counterparts' concerns about the impact the interchange fee provision could have on community banks. As we discussed in a comment letter to the Federal Reserve Board, we do not fully understand the full impact this provision could have. In the near term, given the condition of the industry, we fear near-term negative consequences for earnings and further impediments to the long-term viability of the community-banking model.
The financial crisis and recession exposed weaknesses in risk management and supervisory practices that need to be addressed, including the following:
- Concentrations;
- Loan underwriting;
- Funding sources, such as brokered deposits and wholesale funding;
- Capital standards; and
- Standards and expectations for de novo institutions.
Unfortunately, the potential solutions to these issues only increase community bankers' concerns. A broad-brush approach, bright line limitations and a checklist of risk management requirements will surely over-tax the industry. We need to ensure that regulatory policy in these areas does not further undermine the very industry it is attempting to strengthen.
Federal Deposit Insurance Corp. Chairwoman Sheila Bair's recent comments about community banks and CRE lending reflect this sentiment.
‘I believe that supervisory policies need to reflect the reality that most community banks are specialty CRE lenders and that examiners need to focus on assuring quality underwriting standards and effective management of those concentrations,’ she said. ‘Though hundreds of small banks have become troubled or failed because of CRE concentrations, thousands more have successfully managed those portfolios. We need to learn from the success stories and promote broader adoption of proven risk management tools for banks concentrated in CRE.’
The economic crisis, the resulting recession, and now enhanced regulatory burden have combined to create an incredibly challenging operating environment for community banks. More consideration must be made by policymakers to understand the long-term impact our decisions and actions have upon the community banking system.
To that end, I have a few suggestions for implementing a revamped regulatory regime while still encouraging the success of the community banking system.
First, there must be continued coordination and consultation between federal and state regulators to best understand how local and national economies will be impacted by new regulations. I believe the most effective system of financial supervision is one characterized by both state and federal financial regulation – what my colleague from New York, Superintendent of Banks Richard Neiman, refers to as ‘cooperative federalism.’ A system of supervision based on cooperative federalism allows for comprehensive, effective and efficient supervision of the banking industry.
Key components of a state/federal supervisory system are the proximity of state regulators to the entities we supervise, and our ability to identify emerging threats or trends in the banking industry, as well as the ability of federal regulators to implement regulations on a national scale and make them applicable to all market participants.
Second, more analysis is needed to fully understand and appreciate the valuable relationship between community banks and small business. My fellow state regulators and I know anecdotally that the community banking system is at peril, and therefore. the small business sector in the U.S. is also in jeopardy. However, the lack of data and analysis in this area has failed to provide a clear enough understanding to appreciate industry diversity and a viable and competitive community banking system.
Significant resources at the federal level exist to perform such analysis and would provide tremendous benefit to the national economy, but also to your state and local economies. Across the country, different communities benefit from unique community banks that are specifically tailored to meet their needs. Gathering data to better understand and appreciate the business models of community banks will provide greater appreciation for this significant issue on a greater scale and will provide clear justification for a national priority to ensure public policy enables and does not overly burden community banking.
Finally, the Conference of State Banking Supervisors recommends that Congress and the federal regulators investigate ways to tailor regulatory requirements to institutions based upon their size, complexity, geographic location, management structure and lines of business. The current ‘one size fits all’ approach to regulation, both in terms of safety and soundness and compliance supervision, has fallen harder on community banks and driven dramatic consolidation and bifurcation of the banking industry.
Perhaps it is time to explore a bifurcated system of supervision. After all, a bank with a single branch in one state has a dramatically different business model than Bank of America or Citigroup, so it should not be held accountable to the same supervisory structure as institutions that employ thousands of people and operate in hundreds of nations.
John P. Ducrest is commissioner of the Louisiana Office of Financial Institutions. This article is adapted and edited from recent testimony delivered before the U.S. Senate Financial Institutions and Consumer Protection Subcommittee. The original text is available here.
