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Thanks to Dodd-Frank, Community Banks Are Too Small to Survive

Politicians may wax lyrical on the importance of community banks to local economies and regulators may claim the focus of their efforts is on institutions that are "too big to fail," but the facts tell a different story.

The Dodd-Frank Act, sold to the public as the tamer of the "Wall Street Titans," may well end up having a disproportionate impact on smaller institutions, thanks to the costs of capital implications of being "not too big to fail" and the advent of the Consumer Financial Protection Bureau.

And things are really bad when even the regulators begin to notice. Comptroller Thomas Curry stated in his speech to the Florida Bankers Association last month that Dodd-Frank contained "a number of provisions that… many in the industry thought would not apply to community institutions." In particular, the move away from institutional reliance on credit ratings agencies will have a profound impact on community banks,  which lack the institutional structures and analytical resources to undertake independent due diligence.

Granted, a retreat from the largely fictitious ratings system that continues to dominate the capital markets and lending practices is not a bad thing, even if it puts smaller banks at a disadvantage in the market. Nor is encouraging banks to undertake some diligence on their clients.

More problematic is the implicit government guarantee that underpinned the 2008 bailouts – and which, despite claims to the contrary, lives on in the Dodd-Frank systemic risk regime. Prior to the crisis, community banks were mostly subject to lower funding costs, being largely deposit-taking institutions that avoided the costly debt-financing activities of larger institutions. As of the second quarter and using the cost of funding earning assets as a proxy for the cost of capital, banks with in excess of $1 billion in assets have almost half (0.39%) the cost of capital of institutions with less than $1 billion (0.74%), according to the FDIC's latest Quarterly Banking Profile. This puts smaller banks at a distinct disadvantage unrelated to their activities and financial health.

Furthermore, the rules and regulations developed by the CFPB will affect all commercial banks, regardless of size, and will have a disproportionate impact on community banks (even though, in theory, the agency should supervise only financial institutions with assets in excess of $10 billion).

The largest banks, in particular those that operate in the more complex capital markets arena, are unlikely to regard the CFPB as anything other than additional red tape, in part because they serve a different market. Large corporates are unlikely to run to the CFPB if they feel underserved by a Goldman or a Citigroup.

In contrast, if public statements are anything to go by, the CFPB is clearly targeting its efforts at the consumers who use community banks. The CFPB's website highlights the bureau's focus on groups such as pensioners, students and consumers who lack financial literacy. And that means significant compliance costs that community banks will find harder to absorb.

And community banks face challenges beyond the unseen small-bank implications of Dodd-Frank. The Fed's artificially low interest rate environment means the traditional business of lending is not especially lucrative and the disincentive to save makes deposits harder to come by. So the banks will need to focus on generating other types of fee-based revenue, which will hurt consumers who will need to pay more for loans and basic banking services, or quit the market.

All of these factors are also coupled with distinct unwillingness on the part of federal regulators to approve new bank charters. In 2006, they approved over 170 new national bank charters, excluding conversions and the purchase of assets of failed banks. In 2011, the OCC approved a single de novo national bank charter.

It wasn't always so. For decades, community and regional banks received special protection from state banking laws and the implicit guarantee provided by federal deposit insurance. Despite the many community bank failures during and in the aftermath of the 2008 financial crisis, the U.S. still has more than 7,000 banks – more than any other country. 

It is questionable whether this structure would ever have developed without the protections afforded to smaller banks before the crisis, and whether the U.S. market needs quite so many banks.  International experience suggests not. The Canadian and South African banking systems – the world's "soundest" according to the World Economic Forum's 2012 Global Competitiveness Report – are both extremely concentrated.

Though some consolidation – particularly outside of the largest few – is probably a good thing, it should be driven by the market, independent of regulatory and short-term interest rate considerations and regulators should give new, innovative firms sufficient space and flexibility to survive. Crippling community banks under a heavy regulatory weight is not the way to bring about structural change.

Louise C. Bennetts is the associate director of financial regulation studies at the Cato Institute.

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Comments (15)
Didn't the Independent Community Bankers' Association back Dodd-Frank? How does Camden Fine and his board keep their jobs?
Posted by gtownsend | Monday, November 19 2012 at 9:15AM ET
Didn't the Independent Community Bankers' Association back Dodd-Frank? How does Camden Fine and his board keep their jobs?
Posted by gtownsend | Monday, November 19 2012 at 9:15AM ET
Make them public utilities. Protect them from competition, guarantee them a modest profit, and ensure they adhere to a defined business model. Recall that our last banking crisis was among these self-same savings and loans, and that took almost a decade to unwind. As one commenter noted, we don't know how many and which kind of banks the economy needs, but this isn't exactly impossible to estimate. Nothing else is going to work.
Posted by papicek | Monday, November 12 2012 at 4:19PM ET
One hallmark of our regulatory system is that it develops bit by bit as situations arise, not according to a an overall master plan. One consequence of that is a tendency to become complicated. Simple capital standards weren't perfect. They set the same standard for a bank with higher risk assets than lower risk which spawned a movement to do risk weighting. An when those first simpler risk weightings proved not perfectly logical we went further down that road to Basel II and now Basel III. A similar trend can be seen in consumer protection laws and regulations. To bring all of this down to Earth, commenters like masaccio should attend a meeting of true community bankers describing what they are doing to comply with all of these layers of new requirements. Some small community banks, particularly in rural areas, still have "bookkeepers", not CFOs. They may use a local lawyer to help comply with the myriad of laws fully understood only by a few specialists based mostly in the financial centers. I don't think the issue is getting rid of regulation but rather building a regulatory system that works. In my view, that means a simpler system regulated by bright, honest and well trained people who can see the risks in each bank and prescribe appropriate measures, if needed, to address those risks. That is less uniform but still has common baselines and avoids multiple problems including the tendency to become too complicated to understand.
Posted by gsutton | Monday, November 12 2012 at 2:53PM ET
Cato is an arm of the Koch Brothers. It has no independent thinkers left, and this piece is a good example.

The organization is now determined to wipe out any and all regulation through any means available, including publishing nonsense like this.

Let me just point to the most obvious point: the silly notion that "markets" should dictate the pace of consolidation, which forms the conclusion of this piece. It must have been an oversight that the author doesn't tell us who or what this market is. That is because this is a stock piece of nonsense used to disguise the absence of logic.

There is no market, there are only other banks. Our magician author wants to say that regulators should have no role in bank mergers, but that is arrant nonsense, because the FDIC insures both banks and will insure the survivor in the merger.

But we all appreciate knowing what David and Charles think about things, now don't we?
Posted by Ed Walker | Monday, November 12 2012 at 1:06PM ET
Thanks for writing this article, Louise. This, along with the Fed's inclusion of community banks in the Basil III framework are really body blows to community banks. In contrast to the comment above, as a community bank CEO, I know the ABA is strongly representing the community bank cause in an effort to maintain the strength of this sector.
Posted by Jeff Szyperski | Monday, November 12 2012 at 12:38PM ET
Thanks for writing this article, Louise. This, along with the Fed's inclusion of community banks in the Basil III framework are really body blows to community banks. In contrast to the comment above, as a community bank CEO, I know the ABA is strongly representing the community bank cause in an effort to maintain the strength of this sector.
Posted by Jeff Szyperski | Monday, November 12 2012 at 12:37PM ET
The comment by bankceo: "A re-ocuring theme recently of the ABA is the demise of Commnity Banks. Let's get on the other side of this and start representing our cause. We need relief from Dodd Frank, not prophecy of doom."

Absolutely right. What is your institution doing to move this representation forward -- any ideas/actions you can share with the rest of us?
Posted by Writer802 | Monday, November 12 2012 at 11:50AM ET
If CFPB was really for the consumer they would reinvent products like mortgages and start with a blank slate rather than trying to redo each piece like the Truth in lending form. Start over,forget everytning you know, and every regulation on the books. The only way to protect the consumer is to create products that are simple enough for the consumer to understand. The complexity of the CFPB will only put smalls out of business and cost the consumer more.
Posted by dahlers | Monday, November 12 2012 at 11:44AM ET
Very timely topic and analysis. Having spent the good part of 50 years studying and writing about bank regulation and bank sturcture issues, I venture thea the structure of banking in the U.S. would have been much less concentrated at the top 10 with oabout the same number of independent banks and holding companies as we have now and maybe another 300 community banks that got hung up in the residential and commercial real estate collapse. Bernard Shull and Geral Hanweck published a book entitled "Bank Mergers in a Deregulated Environment: Promise and Peril, 2002 where they presnted a table clearly showing that the cost of funds for small banks was far greater than for any other class of banks and even larger yet compared with the top 10 banks. Nothing has changed except community banks are being squeezed by the regulators to "manage" risks more aggressively than in the past to the point that regulators are making lending decisions for these banks. your conclusion that these decisions should be left to the market so that banks could find their own way and not the way of the "CYA" regulators can only help improve economic growth and innovation. These are both now stymed by the heavy hand of the bank regulators and anticompetitve behavior of the largest banking companies.
Posted by Gerald Hanweck | Monday, November 12 2012 at 11:26AM ET
Very timely topic and analysis. Having spent the good part of 50 years studying and writing about bank regulation and bank sturcture issues, I venture thea the structure of banking in the U.S. would have been much less concentrated at the top 10 with oabout the same number of independent banks and holding companies as we have now and maybe another 300 community banks that got hung up in the residential and commercial real estate collapse. Bernard Shull and Geral Hanweck published a book entitled "Bank Mergers in a Deregulated Environment: Promise and Peril, 2002 where they presnted a table clearly showing that the cost of funds for small banks was far greater than for any other class of banks and even larger yet compared with the top 10 banks. Nothing has changed except community banks are being squeezed by the regulators to "manage" risks more aggressively than in the past to the point that regulators are making lending decisions for these banks. your conclusion that these decisions should be left to the market so that banks could find their own way and not the way of the "CYA" regulators can only help improve economic growth and innovation. These are both now stymed by the heavy hand of the bank regulators and anticompetitve behavior of the largest banking companies.
Posted by Gerald Hanweck | Monday, November 12 2012 at 11:26AM ET
A re-ocuring theme recently of the ABA is the demise of Commnity Banks. Let's get on the other side of this and start representing our cause. We need relief from Dodd Frank, not prophecy of doom.
Posted by James W Everson United Bancorp, Inc. CEO | Monday, November 12 2012 at 11:11AM ET
One of the key points of this piece is that no one knows how many and what size banks the U.S. should have. The only people we can trust with that decision are bank customers, who come in all sizes and needs. We harm those very customers when we let bank regulation make those decisions.
Posted by WayneAbernathy | Monday, November 12 2012 at 10:48AM ET
Good article as it pertains to one aspect of banking. If the smaller banks want to equalize the situation, they can place significant pressure on the CFPB to investigate some of the larger banks which are most responsible for unfair, deceptive, abusive, acts and practices as they contribute to making the middle and lower classes poorer through oligopolistic pricing and providing terrible products. You only need to look at credit cards,payday lending, and mortgages for starters. The community banks need to use their associations to pressure the CFPB and start acting in the best interest of all customers if they want any credibility from the CFPB and from their community. If they continue to remain silent, then shame on them.
Posted by frankarauscher | Monday, November 12 2012 at 10:19AM ET
Amen. Amen. And...aaaaamen.
Posted by My 2 Cents | Friday, November 09 2012 at 9:32PM ET
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