REQUIRED READING: I hear from a lot of community bankers who are concerned that the community banking model might not survive. Many paint a picture so bleak that they see only personal retirement or sale of the bank as viable strategies. I completely understand how tiring it is to fight a financial crisis and survive a deep recession followed by a weak recovery only to confront what seems to be a tsunami of new regulations.
I felt all of those same emotions in 1991. I was a community banker then. We had survived the savings and loan crisis with some bruises, but we were still standing. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 had been followed by the Federal Deposit Insurance Corp. Improvement Act in 1991. I had more new regulations stacked on my desk than I had employees in the bank. My bank had just reached the $100 million mark in total assets through the purchase of two branches from a failing thrift.
Even more daunting for me was the sudden death of my bank's CEO, leaving me as the new CEO. Frankly, I did not know how I was going to tackle all that lay in front of us. But those dark days in 1991 were followed by 15 years of exceptionally strong performance for all banks, including my own. And those experiences – the good and the bad – give me confidence in predicting a bright future for community banking today.
Just as the seeds of a crisis are often sown in earlier boom times, strength can be forged during the tough times that follow a crisis. As we did in the early 1990s, bankers and regulators today have learned from the lessons of the crisis and are determined not to repeat the mistakes of the past.
Credit metrics are now improving in most banks as problem loans have been addressed and resolved and new credit underwriting has been quite restrictive for a number of years. Deposit growth has outpaced loan demand, reliance on wholesale funding has been reduced and capital positions are stronger.
The interest-margin pressure banks face today is partly due to low interest rates and partly due to weak loan demand, both of which are consequences of a sluggish economy. As the economic recovery gains momentum, however, both of these conditions should reverse and give bankers the opportunity to deploy the liquidity and capital they have amassed to the benefit of their shareholders and local economies.
Community bankers are being heard
Even as they anticipate economic recovery, however, community bankers worry that the burden of new regulations may inhibit their ability to lend in their communities or prohibitively increase the costs of such lending. We certainly understand this concern. Federal Reserve research over the years has confirmed that the burden of regulations falls disproportionately upon smaller banks.
Supervisors at the Federal Reserve Bank of Minneapolis have recently tried to quantify this effect. To do so, they used survey data to estimate the relative number of new employees that banks of different sizes might need to hire in response to the same regulatory requirement. Using Call Report data from 2011, they estimated in their preliminary analysis that hiring one additional employee would reduce the return on assets by 23 basis points (bps) for the median bank in the group of smallest banks, those with total assets of $50 million or less.
To put this estimate in perspective, such a decline could cause about 13% of the banks of that size to go from profitable to unprofitable. As a comparison, given the same increase in regulation, they assume banks with between $500 million and $1 billion in total assets would hire three employees and experience a decline of about 4 bps in return on assets for the median bank. While this is still a significant effect, very few banks in this group would go from being profitable to unprofitable as a result of the regulatory burden.
Regulatory overreaction to a crisis is always a risk. But this time, I think community bankers have been more successful than they realize in making the case against one-size-fits-all regulation. I cannot remember a time when I have seen more regulatory proposals drafted that differentiate between banks based on size or complexity. I urge you to continue to identify the regulatory requirements that are the most onerous to your business model and continue to suggest alternatives to achieve those regulatory objectives in a less intrusive way.
In fact, most of the regulations required by the Dodd-Frank Act are directed primarily at larger, systemically important banks, and many of the act's provisions specifically exempt community banks. For example, banks with less than $10 billion in total assets were exempted from a number of the debit interchange restrictions, and early studies indicate that those exemptions are working.
In addition, formal stress testing was required only for banks with total assets of $10 billion or more. In implementing these requirements for the larger banks, the bank regulatory agencies specifically indicated that capital stress testing would not be required for community banks. This does not mean that community banks are exempt from prudent risk management, but rather that smaller banks should think about the negative shocks that could affect their business in the future and tailor their risk-management procedures to the risks and complexities of their individual business models.
The Consumer Financial Protection Bureau (CFPB) recently released final rules defining qualified mortgages that include safe harbors for mortgages that meet specific loan term and pricing criteria, including certain balloon loans made by community banks in rural or underserved areas. At the same time, they issued a new proposal that contains additional community bank exceptions, as well as a question about the treatment of loans used to refinance balloon payments on mortgages that community banks may already have on their books.
Noting that smaller institutions have already demonstrated that they generally do a good job of servicing the loans they originate and that the investments necessary to meet the requirements would be unduly onerous for institutions that service a small number of loans, the CFPB also exempted most community banks from many of the provisions of new servicing requirements. I think such exceptions are especially important because, as I discussed in a recent speech and will touch upon later in my remarks, Federal Reserve research has shown that (1) community banks are important lenders in the mortgage market, (2) those mortgage loans represent a significant portion of community bank lending and (3) community banks are quite responsible in their practices.
At the Federal Reserve, we have formalized our process for considering the unique characteristics of community banks as we craft regulatory and supervisory policies. A few years ago, we created a subcommittee of the board, which I chair, that makes recommendations about matters related to community bank supervision and regulation.
This subcommittee reviews all regulatory proposals and supervisory guidance with an eye toward the possible effects on community banks. Remembering the days when I had to find time to read all those new regulations stacked up on my desk, I have insisted that all new proposals and rules start with a clear statement of their applicability to community banks so that bankers can spend their time on the rules and guidance that apply to them.
This approach was put into practice in a different way last year when the banking agencies issued proposals for capital regulations that incorporated requirements of the Dodd-Frank Act and the Basel agreement. To help community banks identify the provisions that affected them and submit their comments more easily, the proposal included a short summary of the provisions that were most likely to affect community banks.
We received more than 2,000 comments, many from community banks, and we are reviewing them. It is too early in the process to know how we and the other agencies are going to address the issues raised or when final rules may be released. But what I can promise is that before we issue final capital rules, we will do everything possible to address the concerns that have been expressed by community bankers and still achieve the goal of having strong levels of high-quality capital – built up over a reasonable and realistic transitional period – in banks of all sizes, including community banks.
Community bank research
To help us better understand community bank issues, our subcommittee established an informal working group of economists from both the research and supervision functions in the Federal Reserve System. The group is focused on understanding the factors that influence the viability and performance of community banks including, importantly, the effect of regulatory changes and their associated costs and benefits. Members of this working group are exploring a number of interesting topics that I hope will help us to better understand the issues that affect community banks and, where appropriate, have a practical impact on how we supervise these banks.
For example, a recent study undertaken by two Federal Reserve Board economists explores the determinants of community bank profitability from 1992 through 2010. The findings indicate that a number of bank characteristics are strongly correlated with performance, including relative bank size, portfolio composition and management quality.
Within the group of banks with less than $1 billion in total consolidated assets included in this study, larger bank size is associated with significantly higher profitability. Community banks with higher portfolio shares of real estate loans earn significantly lower profits, while those with higher portfolio shares of construction loans earn higher profits through most of the study period.
But, perhaps not surprisingly, the latter relationship does not hold for 2008 through 2010, when greater reliance on construction lending is associated with lower profitability. Managerial quality, as measured by the management component of the banks' regulatory ratings, is strongly related to bank profitability. Moreover, the strength of the relationship increases during and immediately after the financial crisis, confirming that management quality is particularly important during times of economic stress.
Factors outside the control of bank management, however, are also importantly related to profitability, particularly over the past several years. For instance, it is not surprising that community banks operating in markets experiencing high unemployment rates have been less profitable since the financial crisis. Perhaps less obvious is that in urban markets, community bank profitability tends to decrease as the size of the market increases.
One might suspect that this relationship derives from a more competitive landscape in larger urban areas; however, no relationship between market concentration and profits is evident in urban markets. In contrast, in rural areas, higher market concentration is associated with higher community bank profitability throughout most of the study period.
In addition, the study finds that community banks operating in rural markets consistently earn higher average rates of return than do community banks operating in urban markets.
In a separate analysis of deposit market competition that may form the basis for a new research paper, one researcher has documented the competitive strength of community banks, especially in rural markets. Although the nationwide share of total deposits held by banks with assets of less than $10 billion has declined over the past decade, in rural markets their deposit market share has increased slightly.
Moreover, banks with assets of less than $10 billion retained their share of rural market deposits throughout the recent recession and recovery. At a more micro level, banks with assets of less than $10 billion gained market share in more than two-thirds of rural banking markets and in nearly half of urban markets between 2003 and 2012.
Expansion of deposit insurance during the crisis likely helped all banks retain deposits and may have changed competition somewhat. Deposit insurance has now been permanently increased from $100,000 to $250,000 per depositor, but the unlimited deposit insurance for non-interest-bearing transaction accounts was allowed to expire at the end of 2012.
We are watching deposit movement carefully, but so far have seen little evidence of deposits moving out of the banking system or, as some had feared, moving from smaller banks to larger banks perceived as ‘too big to fail.’ My own expectation is that, given all of the enhanced regulatory requirements that apply to larger banks, those larger banks will focus their efforts on large urban markets, and community banks will be even more competitive and more vital to the economic well-being of rural, suburban, and small urban markets.
Researchers at the Federal Reserve Bank of St. Louis took a different approach to measuring community bank success. Studying banks with total assets of less than $10 billion, the researchers attempted to identify the differences between banks that they classified as ‘thriving’ and those that they classified as ‘surviving.’ Banks were identified as thriving if they maintained the highest supervisory rating continuously from 2006 through the end of 2011. Approximately 700 banks met this condition. The roughly 4,500 banks in the study that did not qualify as thriving and did not fail or merge out of existence during the period were classified as surviving.
After categorizing the banks, the first phase of analysis looked at the location and size of the thriving banks. Thriving banks were found in 40 of the 50 states, but were concentrated in states with larger economic contributions from agriculture and energy, which held up relatively well during the downturn. The fewest thriving banks were found on the West Coast and in the Southeast, where real estate values fell the most.
This pattern is consistent with previous Federal Reserve studies, which found that bank performance is heavily affected by the local economy, but I think it is important to note that even in states with high unemployment rates or sharp declines in property values, some community banks were able to thrive.
The St. Louis study did not find the thriving banks to be concentrated in any particular size range. Many had total assets of less than $50 million as of December 2011, but others had total assets between $1 billion and $10 billion. And thriving banks did more than just rate well with supervisors – the thriving banks outperformed the surviving banks on a wide range of performance indicators, including return on assets, return on equity, loan losses, provision expense, efficiency ratio, asset growth, net interest margin and net non-interest margin.
Looking at balance sheet structure, when the researchers compared the characteristics of thriving banks with surviving banks, they found that the thriving banks had lower levels of loans-to-total-assets and were more reliant on core deposits. Thriving banks also had lower concentrations in commercial real estate lending and much lower concentrations in construction and land development loans.
Instead, thriving banks were slightly more concentrated in one- to four-family mortgage loans held in portfolio, as well as consumer loans. Despite these overall balance sheet findings, the researchers also noted the wide diversity of business models that they found among the thriving banks.
Recognizing that a large part of good performance comes from factors that are more difficult to measure statistically, the researchers examined a sample of comments in examination reports and found that thriving banks benefited from a strong and localized customer service focus with high visibility in the community, conservative underwriting and products that were profitable and met customer needs. They supplemented their review of examination reports by interviewing management at some of the thriving banks.
The bankers they interviewed attributed their success to strong ties to the community, relationship banking, conservative underwriting and a focus on products and markets they understood. These results were strikingly similar to the results of interviews in separate studies at the Federal Reserve Bank of Kansas City and the Federal Reserve Bank of Richmond.
These studies confirm what experience has already taught me: Community banks that have deep ties to the community, engaged managers and directors, conservative underwriting and strong risk management will not only survive, but thrive, even in adverse conditions.
Elizabeth A. Duke is a governor of the Federal Reserve System. This article is adapted and edited from a speech delivered on Feb. 5 at the Southeastern Bank Management and Directors Conference, held at the University of Georgia's Terry College of Business in Duluth, Ga. The original text is available online.