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Why Washington Wants Community Banks Out of the Way

The banking system is under pressure — particularly community banks, which have for years been the stalwarts of economic and job growth. Now it appears Washington may just want them out of the way.

Following a two-decade decline to less than half their previous number, the future role and existence of community banks is threatened by regulatory willingness to restrict new charters and accelerated pressure on capital and management.

They are suffering weak demand for loans, credit quality difficulties, growing competition, declining spreads and income sources and rising expenses. Most are today unable to operate with sufficient scale to provide the kind of returns that would attract capital. The result leads one to question the future viability of community banks and expect their continuing decline in number and influence. 

By way of reference, the banking system of the United States is composed of the five largest banks that control over 50% of the banking assets; a few hundred regional banks; and more than 6,000 community banks, defined as banks holding less than $1 billion in assets. 

The typical community bank's focus is on serving local small or entrepreneurial businesses, small agricultural clients and local individuals in rural areas, small cities and defined communities in large cities and urban areas. Community banks account for 92% of all banks, by number, and nearly 30% of total branch locations, yet hold only 11.5% of total banking assets — down from 26% a quarter century ago.

Since 1990 the nation's small businesses have created nearly three quarters of all the new jobs. Today these businesses collectively employ about half the nation's private sector workers. Their efforts produce 50% of nonfarm real GDP. 

About 17.6 million of the 23.3 million active businesses operate independently without payroll employees. Of the remainder, there are 4.6 million companies that operate with 100 employees or less. These two groups are the primary target customers of many community banks. However, competition has muscled in.

In the late 1980s the large banks shunned most small businesses as too risky and costly to serve compared to other opportunities. But over this past two decades, advancing technology, centralized operations and the need to find new areas of profitability have altered their view of this extensive market. 

Large banks became aggressively engaged in providing better-priced, technology-based and -aided credit and deposit services to small businesses and farms. During the same period many unregulated businesses — shadow banks — have been formed to provide financial services to small businesses, competitive with what banks offer.

One of the primary vehicles of large bank and shadow bank competition in meeting the needs of the smallest of these businesses has been business credit cards. A 2008 survey by the National Small Business Association found that credit cards were now the most common source of financing for America's small-business owners.

As the result of this new competition, growing technology and aggressive regulation many community bank revenue sources have been lost or diminished. These banks have discontinued as too costly, or found reduced demand for numerous noninterest income services. In addition most community banks no longer finance auto dealers, customer cars, or offer consumer or business credit cards. They no longer offer furniture financing plans, or finance business inventory and accounts receivable. In many cases they also collect fewer account service charges, sell fewer checks, and collect fewer loan, return check or overdraft fees. In addition, thanks to competition from money market funds (a subspecies of shadow bank) they no longer benefit from the level of free demand deposits from small-business customers that once amounted to nearly 50% of total business loans.

With fewer small-business and consumer loan opportunities, community banks' revenues and returns on capital have diminished. To overcome these difficulties many community banks changed their focus to financing more lucrative commercial real estate transactions. As a consequence many community banks have experienced self-inflicted troubles because of portfolio concentrations that are experiencing stress and in many cases threatening their viability. While their holdings of commercial and consumer loan assets have declined over the past two decades, the level of portfolio commercial real estate loans increased from 30% to 53% of total community bank assets.

Though a portion of these CRE loans financed owner-occupied small businesses, most recent transactions funded speculative ventures during strong economic times. These changes have permitted sustained asset growth in community banks but, as history has shown, resulted in more failures and an increase in troubled small banks. 

From the regulatory perspective, community banks will be required to build higher capital levels under the international Basel standards and are under aggressive regulatory scrutiny resulting from thousands of pages of new regulations, including those emanating from Dodd-Frank. The impact has been reduced leverage and increased expenses to maintain regulatory compliance.

Politicians and senior regulators consistently and publically profess the value and importance of community banks to our economy, yet their recent actions suggest otherwise. The flood of new regulation, demands for more capital, harsh enforcement plus an unexplained three-year-old de facto moratorium on de novo bank charters lead one to believe that Washington really wants fewer community banks.

Why else would these aggressive actions be taking place? The authorities seem to be moving toward a universe of fewer and larger banks, even though such changes harm many local communities and their economies.

They most likely see the changes in the community bank business model that have taken place over the past 20 years. They are not happy with the level of community bank failures or a continuing large number of troubled small banks. They are well aware of how small businesses now meet much of their banking needs through large or shadow banks with better-priced or more flexible credit and financial services. They also see the risks of a continued focus on commercial real estate loans and the community banks' limited alternatives to maintain a meaningful return of capital. 

In the final analysis it seems clear that Washington wants and sees a smaller, stronger banking industry. Given the facts and recent experience it's hard to argue otherwise and there seems to be nothing that will alter this direction. 

Robert H. Smith, the former chairman and chief executive of Security Pacific Corp., is a founder and director of Commerce National Bank in Newport Beach, Calif.


(16) Comments



Comments (16)
I think Robert Smith makes many valid points. Do I think there is a conspiracy against community banks? No. I think it stems more from ignorance and politics than it does from nefarious actions by a group. I testified before a congressional hearing last April. I testified that I believe that many of the "policy makers" at upper levels, i.e. Chairman Bernanke, FDIC Chairman, Congressional leaders, etc, are simply unaware (putting it nicely) about the "unintended consequences" of their actions. There is simply a disconnect believe the theorectical world and the real world. We are simply not "feeling the love". I also told them, "In the movie "It's a Wonderful Life", George Bailey's crazy Uncle Billy almost unintentially and inadvertantly destroyed the institution that he loved. I have a crazy uncle, as well.... his name is Uncle Sam. That is why it is so very important that we each try and do our part to "educate" our respective representatives to what the real world on main street is all about.
Posted by GeorgeBailey | Friday, October 26 2012 at 5:30PM ET
Hmm, my comment got cut off somehow.

Was saying that Durbin gives the little guys a leg up thanks to the
Posted by Michael Wilson | Thursday, October 25 2012 at 4:43PM ET
Correlation doesn't equal causation, even if there are logical motives behind the accused "cause agent".

Based on the data, banking's consolidation movement is well into its third decade and shows no sign of slowing, and this has remained true through large shifts in political power, economic conditions, regulatory burdens and fashion sense.

Mom and pop electronic stores or grocery shops are basically gone too, but I see no government conspiracy there.

Community banks have the same challenge as those small retailers -- no economy of scale, minor or no product differentiation, legacy technology and a brick and mortar infrastructure that consumers aren't willing to pay for.

If anything, the Durbin Amendment of Dodd-Frank was an attempt to give the little guys a leg up with the
Posted by Michael Wilson | Thursday, October 25 2012 at 4:09PM ET
Community bankers hear the same thing from customers every day - we don't like the big banks. Unfortunately, our customers will be our demise. They "love" community banks; however, where is the concerted effort from them to lobby their government officials on behalf of the community banks? Customers don't like all the regulations. What do they do? Get angry with that bank then go find one that is satisfied with a 2 or 3 in compliance. The community banks weren't the predatory lenders, but that doesn't stop the customers of community banks from jumping on the "I'm not going to pay my mortgage Obama bandwagon".

The question is: Can we make customers care enough about their local community to take action and get involved - all while we're trying to generate quality loan assets and squeeze them for fee income?
Posted by jlb90a | Wednesday, October 24 2012 at 11:59AM ET
I have felt for years that the government has a way to force out the small business, no matter wheather it is a bank, a corner service station, a mom and pop store, or a farm.
They have a way to regulate the small business out.
Posted by loanmaker | Wednesday, October 24 2012 at 10:43AM ET
The decades long squeeze that community banks have experienced hardly make a case for the conspiracy theory in the headline. Most of what Mr. Smith describes is simply the failure of community banks to compete effectively as their operating environment changes with new ocmpetitors, changed regulation (deregulation in some areas, more in others), large banks exploiting economy of scale, etc. You could as easily argue that the the failure of the government to play favorites on behalf of community banks has subjected those institutions to market forces that are "culling the unfit."

Of course the benefits that community banks provide seem to justify some preferential government treatment even at risk of contradicting the will of the market god. How to do that is a different think piece for American Banker... Should we exempt community banks from provisions of Dodd-Frank, level the field by subjecting shadow banks to more regulation, do away with TBTF and the some accompanying economy of scale advantages, or just let community banks go the way of the blacksmith shop and concede that the world is different than a generation ago?
Posted by j.doe | Wednesday, October 24 2012 at 10:39AM ET
The community bank's are under siege by the regulators. I run a small bank in the East and we have been told directly that we'll need to be at least $1 billion in assets to survive. They'll use all means at their disposal to effect this decline, including additional capital requirements, enforcement actions, etc. Our importance to small business is well documented, but the legislators don't act. We'll be left with a less-robust economy, less risk taking...much like Europe. Lets all hope that regime change happens, and the community banks are recognized for the critical part they play in prosperity and job creation.
Posted by Mr Drysdale | Wednesday, October 24 2012 at 6:07AM ET
There used to be a size and complexity rule of thumb. You didn't judge small banks against large bank standards. It seems that increasingly bank examiners are using the one-size-fits-all approach. Unfortunate.
Posted by mrjessetorres | Tuesday, October 23 2012 at 11:12PM ET
Interesting how some folks, without the burden of facts, quickly assign blame for an observed phenomenon. Although Mr. Smith clearly states the decline in community bank numbers began two decades ago, gscull concludes this is due to some Democratic party strategy, implying George W. Bush fought tooth and nail to reverse this decline during his eight-year term. Also, how would gscull perceive Democrats "controlling" the banking system under a Republican administration? Actually, federal regulators believe the community bank business model is "broken", and are actively seeking ways to mend it, given legislative and safety and soundness constraints. They would appreciate constructive comments, but not conspiracy theories.
Posted by Mr. Sandypoint | Tuesday, October 23 2012 at 8:00PM ET
It would be heresy for anyone to actually say out loud that the Democratic Party of the US Government actually would prefer socialism right?? However how is this any different than the French who have what 13 banks and the handful of biggest ones are nothing but Presidential puppets. Oh...and who always seems to be at the White House?? Jamie Dimon. The Democrats would like nothing more than to replicate the French banking system so that could completely control it. Community banks are thorns in the Democrats sides... Voila!
Posted by gscull | Tuesday, October 23 2012 at 6:03PM ET
Bureaucrats like to go home at 5pm. Less businesses to regulate means less time spent regulating them. A perfect example is how the government has essentially eliminated small dairy farms through the most ridiculous restrictions and pricing mechanism imaginable. This is primarily driven by the big co-ops and milk processors who would rather have a handful of mega-dairies to deal with than thousands of small farms. They use their financial muscle to get legislators and regulators to do their bidding. It's worked wonderfully for them, and it's still working. Call it the Dairy/Industrial Complex. Or the Milk Mafia. And it will happen to community banks.
Posted by Writer802 | Tuesday, October 23 2012 at 6:03PM ET
I certainly believe the federal regulators want fewer banks. I have actually had a senior official with one of the federal regulatory agencies say "you know, we have at least 2,000 too many banks in this country." This statement has been repeated by at least one senior staffer of the House Financial Services Committee. I haven't been able to discern why there is this strong sentiment due to the fact, as Mr. Smith points out, community banks have such positive impacts in their communities. The OCC, in particular, definately uses a "one size fits all" approach to supervision, which puts their community banks at a distinct disadvantage in their market place. The "conspiracy theory" side of me believes that with fewer banks with which to deal, it will be easier for the federal government to eventually control the banking industry. It can't happen? Who thought that the federal government would control the healthcare system in our country 5 years ago?
Posted by ahump | Tuesday, October 23 2012 at 5:48PM ET
Follow the money! Very large banks have the money and use it through their lobbying team to help get the community banks out of the way. The feds are buying their arguments, I guess. Lesser competition on the local level. Read first sentence.
Posted by jbruff | Tuesday, October 23 2012 at 5:43PM ET
Follow the money! Very large banks have the money and use it through their lobbying team to help get the community banks out of the way. The feds are buying their arguments, I guess. Lesser competition on the local level. Read first sentence.
Posted by jbruff | Tuesday, October 23 2012 at 5:42PM ET
While I find it hard to believe that policymakers in Washington want to kill off the community bank model, one could certainly find the evidence to be persuasive.
Posted by WayneAbernathy | Tuesday, October 23 2012 at 5:33PM ET
Federal financial regulators have been trying to kill off community banks for decades. It's like they see the dual banking system as a personal affront. Once they co-opted the FDIC during the Financial Crisis, they almost got their wish. Now the Fed's QE series and the zero% interest rate environment is trying to kill off all banks that don't operate casino gambling subsidiaries masquerading as investment/trading subs.
Posted by jim_wells | Tuesday, October 23 2012 at 4:47PM ET
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