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Ron J. Feldman is executive vice president and senior policy advisor at the Federal Reserve Bank of Minneapolis.
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The Surprising Truth About Community Bank Consolidation

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Community bankers are well aware of the rising costs of supervision and regulation. These higher costs are likely to reduce earnings for some small banks and, it follows, make some owners more inclined to sell.

However, recent analysis by the Federal Reserve Bank of Minneapolis reveals that the rate of consolidation among community banks has not increased recently. Rather, consolidation rates so far are following historical patterns. This is true even though the cost of increased supervision and regulation is hitting the smallest banks particularly hard.

Identifying the rough costs of increased supervision and regulation is exceptionally difficult. Figuring out how many fewer banks would have consolidated absent that increase in costs with any precision is impossible. So how can we try to put numbers on either development?

To figure out the potential costs of increased regulation and supervision, our study assumes that all these costs show up as more staff. Increased hiring means lower earnings. Of course, banks respond to more costly regulation and supervision in many ways. But possible responses will seem to either reduce revenue or increase costs, resulting in lower earnings. That is the focus of our analysis. We also provide a regulatory cost calculator so that others can make these same calculations using assumptions they find most reasonable.

Using assumptions for the amount of additional hiring caused by more intense supervision and regulation and the cost of the additional staff, our study finds that the smallest banks (those with assets below $50 million) would face almost twice the hit to earnings as other banks, even those with assets between $50 million and $100 million. The reduction in earnings would push roughly 15% of the smallest banks into unprofitability.

Given these effects, one might assume that small bank owners will try to sell, believing they cannot compete effectively. Put another way, the rate of community bank consolidation in an era of increasing supervisory and regulatory costs should be higher than the consolidation rate in the past.

But so far the rate of community bank consolidation is consistent with long-term trends. Our study initially made baseline estimates using data as of mid-2013 of the number of community banks that would be in existence as of mid-2014. We are now updating on a quarterly basis estimates of the amount of community bank consolidation that will occur over the next 12 months so that we can track consolidation over time.

We make these estimatesusing a variety of models that, to over-simplify, assume the type of consolidation we have seen in the past will continue into the future. If these models based on historical patterns fail to estimate future consolidation, we have at least one sign that something about current consolidation is different than what we witnessed in the past. In particular, if the rate of consolidation is higher than expected, one reasonable cause for the pick-up could be higher-cost supervision and regulation.

By way of one example, our most simple baseline estimates as of June 2013 forecasted a national decline of 325 community banks from 6,534 to 6,209 by June 2014. The actual decline in the last two quarters of 2013 was 114 to 6,420, less than our predicted value. That fall translates into an annual rate of decline of 3.5%, which is right around the rates of decline for similar periods in the prior two years and a bit above the roughly 3% annual rate of decline characterizing the last 20 years.

Community banks provide unique services that other financial institutions may be unable to provide in their absence. In particular, community banks make a disproportionate share of loans to smaller firms, who may face relatively high costs moving to another lender. Continued research on the cost of regulation and supervision, and its effects on the number of community banks, is necessary to quantify those costs and the potential effect on bank numbers.

Our work to date suggests that while the smallest banks may be particularly vulnerable to higher regulatory costs, these costs have not shown up as higher-than-expected consolidation among community banks just yet. We will continue to monitor rates of consolidation to identify an increase beyond what would occur based on historical patterns.

Ron J. Feldman is executive vice president and senior policy advisor at the Federal Reserve Bank of Minneapolis. He is the senior officer for Supervision, Regulation and Credit, where he oversees the consumer and safety and soundness supervision of roughly 100 state member banks and about 500 bank holding companies.

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Comments (5)
I think something is missing in the analysis that helps explain the slower than expected consolidation rates. Many if not most community banks are long-standing pillars in their communities. Their employees are not merely "costs" of doing business. They are friends and family. And consolidations almost always mean significant job reductions for one or both parties. So...yes, many of these banks will likely attempt to hang in and hang on to their independence longer than bureaucrats would predict with their models. That doesn't mean that excessive, costly regulations and increasing unpredictability of application and enforcement are no big deals. No, if they stay on this path, DC will likely be successful in the long run in eliminating most small banks. It's just that community bankers fight harder to remain independent (and protect their employees, customers, and communities) than bureaucrats' models currently predict.
Posted by My 2 Cents | Wednesday, May 07 2014 at 11:08PM ET
While the rate of consolidation has not changed, the pace of start-ups is practically zero. That is where the cost burden will continue to decrease the number of banks overall. There will still be start-up opportunities, but it will take very fortunate conditions to make one truly successful.
Posted by pdf70101862 | Thursday, May 08 2014 at 10:53AM ET
This explanation fails to consider why community bank regulation is over the top, inefficient and not essential to the stability of our financial system.
Posted by Rhsmith999 | Thursday, May 08 2014 at 10:54AM ET
For starters, anyone familar with bank regulation would have to chuckle as they read this article. A regulator, a party that plays a pivotal role in the increased regulatory burden faced by community banks, concludes in a study that the regulatory burden probably isn't all that bad because it is not accelerating the consolidation of the banking industry. The inference is that the regulatory burden we hear about is really overstated. If a community bank had its own loan officers review their own loans and then advised its regulator that the loan officers found that everything in the loan portfolio was OK, the regulator would dismiss the analysis out of hand for its lack of independence. Should community bankers be inclined to treat this study in the same manner?

Another source of amusement is the stated assumption in the study that the cost of the increased regulatory burden is only reflected in increased employee cost. Really? Without any study to back me up, my guess is that community banks have greatly incresed their professional fees in an attempt to keep pace with the regulatory burden. It might also be worth examining assessments paid to regulators as a contributing cost of the regulatory burden. Tougher examinations result in harsher ratings which result in higher assessments. And what about interest rates that have been kept at historic low levels. Has this regulatory policy affected profitability of community banks?

The lack of an uptick in sale activity probably has many reasons. I think two reasons should not be overlooked. First, for community banks, capital is difficult to raise. Why would an investor want to place money in a community bank, where there is a good chance the investment will be illiquid (the regulators have incresed their scrutiny of new entrants into the market)and where industry analysis point to a lower return on equity? Moreover, why would someone want to invest at this time when the regulatory environment is perceived to be as hostile as it is?



Posted by jkanevp | Thursday, May 08 2014 at 11:30AM ET
The study's finding that community bank consolidation has not increased recently despite higher regulatory costs does not demonstrate absence of causality, any more than an increase would have been proof of causality. As others have noted, there are a number of factors that drive merger and acquisition activity, including investor sentiment, access to capital, seller price expectations, regulatory resistance (ask M&T), etc. Does the model account for those variables? The indisputable fact is that the regulatory cost burden has increased, translating into lower bank earnings and ROE, with no apparent benefit to the public.
Posted by MrPotter | Thursday, May 08 2014 at 4:39PM ET
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