Coup for community banks could spell disaster for industry

New risks are brewing in the United States’ financial system and are hiding where it’s least expected: in the country’s smallest banks.

Over the past two years, policymakers have systematically rolled back safeguards on so-called community banks. These deregulatory initiatives — many of which took effect on Jan. 1 — are likely to expose the financial system to underappreciated risks.

Ever since the 2008 market crash, policymakers have been so focused on too-big-to-fail megabanks that they have lost sight of the fact that small banks can also propagate systemic risk. That is because when small banks fail, they tend not to fail in isolation. Rather, they collapse en masse.

In fact, every banking crisis in U.S. history — up to and including 2008 — has involved the simultaneous collapse of numerous small institutions. Although the latest recession was typically understood as a “too big to fail” crisis, nearly 500 community banks failed for reasons largely unconnected to those megabanks.

Community banks insist that recent deregulation is warranted because the Dodd-Frank Act and Basel III imposed onerous compliance burdens and made it difficult for them to compete. But these claims are misleading.

In actuality, post-crisis regulatory reforms did not uniquely burden community banks. Dodd-Frank exempted small banks from its most onerous rules, and it introduced generous community bank subsidies that offset many new compliance costs.

Moreover, community banks have increased their market share since 2008 and remain just as profitable as they were before Dodd-Frank.

Nonetheless, the latest reforms have now eased capital requirements, loosened liquidity rules and relaxed supervisory oversight of community banks. These unwarranted rollbacks are likely to increase systemic risks.

Consider the community bank leverage ratio (CBLR). Under a new rule, a bank with less than $10 billion in assets is exempt from all risk-based capital requirements if it maintains a simple leverage ratio of at least 9%.

The elimination of risk-based capital requirements is likely to push new risks onto community bank balance sheets. When subject only to a leverage requirement, a community bank’s investments are treated identically for regulatory capital purposes, regardless of the underlying risk profile.

In response to the CBLR, community banks are likely to increase the riskiness — shedding safe assets like Treasurys in exchange for more volatile loans and securities — in an effort to generate higher returns.

Other recent deregulatory changes are likely to increase systemic risk in the community bank sector as well. For example, the Federal Deposit Insurance Corp. has proposed to weaken restrictions on volatile brokered deposits, which would expose smaller banks to new funding vulnerabilities.

And exempting community banks from the Volcker Rule’s prohibition on speculative investments — as regulators did last year — will permit community banks to amass significant risks that are forbidden to larger banks.

Even worse, these new risks will be more difficult for the banking agencies to detect because regulators have loosened community bank supervisory oversight.

In 2018, Congress expanded the number of community banks eligible for an extended, 18-month exam cycle and condensed regulatory reporting. Unsurprisingly, numerous academic studies have shown that this type of looser supervision leads to elevated risk-taking and more bank failures.

In addition, proposed reforms to the Federal Reserve’s “control” rules will allow private equity and other risk-seeking investors to capitalize on the latest regulatory rollbacks.

A recent study by Wharton Professor Natasha Sarin demonstrated that when a private equity firm invests in a financial company, the company quickly and significantly increases its risk profile. Freed from the Fed’s control restrictions, private equity and other institutional investors will be uniquely apt to exploit emerging weaknesses in community bank oversight.

Even though these reforms are just starting to take effect, there’s already evidence that risks are beginning to shift into community banks. Over the past several years, the market for relatively volatile business loans has migrated from larger banks to smaller firms. Other evidence suggests that community banks would be unable to pass stress tests equivalent to those required of larger banks.

Meanwhile, banks appear to be “bunching” just below the $10 billion asset mark under which they are shielded from more rigorous oversight. There are now almost three times more institutions just below the $10 billion asset threshold relative to those slightly above it — far more than before that figure became a relevant regulatory boundary.

This risk-shifting is a natural consequence of regulatory arbitrage, the well-known phenomenon whereby financial activity migrates across legal boundaries from well-regulated sectors to less-regulated sectors. Regulatory arbitrage among community banks is likely to accelerate as the recent deregulatory initiatives go into effect.

These escalating risks pose a serious problem, since small-bank crises have profound consequences for the broader economy. Community banks provide critical financial products and services to small businesses and entrepreneurs, which larger banks generally do not serve.

When small banks collapse, these borrowers lose access to credit, often during recessionary periods when financial intermediation is most necessary to restore growth. It is essential, therefore, that policymakers halt and reverse the community bank deregulatory trend. The best approach would be for Congress to repeal its latest reforms.

Even in the absence of congressional action, however, there are several steps that regulators could take on their own to better safeguard the community bank sector.

For example, the federal banking agencies could increase the CBLR to ensure that community banks maintain a bigger capital buffer against potential losses. Additionally, the FDIC and the Fed could retract their brokered deposits and control proposals, neither of which is required by statute. The agencies could even implement community bank sector-wide stress tests to monitor emerging risks among small banks in the aggregate.

To be sure, policymakers should not stifle community banks with excessive regulation. But appropriate oversight of small-bank risks is necessary to preserve the long-term viability of the community bank sector.

There is little evidence that recently-enacted regulatory rollbacks were necessary for the smallest banks to remain competitive. At the same time, these reforms threaten undermine the stability of the community bank sector and the broader financial system.

Policymakers ought to reverse the deregulatory trend and focus on safeguarding community banks for the future.