Don't Blame Dodd-Frank for Dwindling Number of Community Banks

There are many things to dislike about the Dodd-Frank Act. Causing the demise of community banks, however, is not one of them.

The current popular narrative holds that since the number of community banks has declined since Dodd-Frank became law in 2010, the law must be responsible. Therefore community banks with assets below $10 billion need regulatory relief to avert extinction.

But this narrative confuses correlation with causation. Yes, the number of community banks has dwindled since 2010. But this is no more proof of Dodd-Frank's ravages than increased community bank profits are proof of the law's success, as Sen. Elizabeth Warren recently claimed. Both arguments rely on classic post hoc fallacies.

Other factors may well have contributed to the reduction in community banks. After all, the number of community banks with assets under $100 million dropped from 13,000 in 1985 to 2,625 in 2010 — before Dodd-Frank was enacted. The number of small community banks had dropped under 1,900 by 2014.

The number of larger community banks with assets between $100 million and $1 billion stayed comparatively stable in this period at roughly 3,800 in 1985, 4,300 in 2010 and 3,900 in 2014. The number of institutions with assets between $1 billion and $10 billion was also stable. Community banks of all sizes did, however, lose share to "too big to fail" banks formed during the big-bank merger waves of the 1990s and the early part of this century.

The decline in the population of small community banks can be attributed to two main factors. The first is the impact of economies of scale. Studies by the Government Accountability Office and the Federal Deposit Insurance Corp. indicate that banking economies of scale set in at the $100 million to $1 billion asset size range—a relatively low level.  A comparison of efficiency ratios from FDIC quarterly reports confirms these findings. In 2014, the smallest community banks had an efficiency ratio of 77%, compared with an efficiency ratio of 69% for those in the $100 million to $1 billion asset bracket. The spread difference in efficiency ratios before the Great Recession was 10%.

The second and more recent factor in the decline in small community banks is the collapse in startup or de novo bank activity following the FDIC's 2009 policy change, which among other things lengthened the heightened supervision period for new banks from three to seven years. More importantly, regulators made the approval process for new banks more difficult, discouraging potential applicants. Consequently, the number of de novo approvals has plunged to just two in the last four years.

De novo activity is cyclical, but it usually recovers following a recession. This time is different, and it's unlikely to improve while the FDIC's policy remains in place.

The best way to stabilize the number of small community banks is to increase de novo activity rather than to make changes to Dodd-Frank. This stance should by no means be taken as support for Dodd-Frank. It merely reflects the facts.

The extinction of community banks has been a concern in the financial industry ever since I entered banking more than thirty years ago. It's undoubtedly true that community banks above the $100 million asset threshold may be challenged by regulation, but they are unlikely to disappear with or without Dodd-Frank. That is why I am, and will continue to be, an investor in these institutions. Their unique local knowledge and relationship-based business model provide a valuable community service, and with the right scale they continue to earn attractive returns.

J.V. Rizzi is a banking industry consultant and investor. He is also an instructor at DePaul University Chicago.