Regulation is disproportionately affecting smaller banks, forcing some to consider selling and others to reconsider their business models.

Community banking executives passed that message along to Congress during a hearing before the House Financial Services subcommittee on financial institutions and consumer credit on Tuesday afternoon.

Banking regulators have overstepped their authority and, as a result, community banks are paying the price, the bankers said. They added that lawmakers should seriously consider legislation to address some of the problems.

"Community banks currently dedicate significant energy and resources to monitoring, detection and reporting of fraud and other financial crimes in compliance with the Bank Secrecy Act," Samuel Vallandingham, president and chief executive of First State Bank in Barboursville, W.Va., said during his prepared remarks. "Reputation in their communities is the stock-in-trade of community banks. The mere prospect of enforcement action is daunting enough to lead risk-averse community banks to shut off access to their payment systems to all but the most-established, low-risk businesses."

Depository institutions filed more than 600,000 suspicious activity reports last year to assist law enforcement, Vallandingham said.

The hearing, scheduled to discuss regulatory relief for small financial institutions, often involved discussion on how to curb Operation Choke Point, even though there was a separate hearing Tuesday dedicated to that issue. Operation Choke Point, which the Justice Department says is meant to crack down on mass market consumer fraud, hurts legitimate businesses without due process, several committee members argued.

"Clearly there were some bad actors and through an investigation those bad actors have been ferretted out," Rep. Ed Perlmutter, D-Colo., said. "But you then don't create a program that continues to sweep more and more businesses into it. You look for the fraud and you punish the fraudulent."

Rep. Leon Westmoreland, R-Ga., asked the executives who were testifying whether their institutions had the chance to comment on the list of merchants that have been flagged as being high risk to do business with. The panelists shook their heads no. "That's a little weird since it involves your industry," Westmoreland said.

Westmoreland also asked if examiners — concerned about the financial institutions' reputational risk — were overlooking other industry problems.

"I'm very concerned about the degree examiners are focusing on reputational risk," William Isaac, global head of financial institutions at FTI Consulting and former chairman of the Federal Deposit Insurance Corp., said. "I don't know anyone who knows what it means, except that the bank is doing something the examiner doesn't like but can't quantify … into the Camels system. I don't think it is a helpful concept."

Bankers did face some tough questions from backers of Operation Choke Point. Rep. Al Green, D-Texas, pointed to the $1.2 million settlement between Four Oaks Bank (FOFN) in North Carolina and the Justice Department as evidence that the operations was necessary and working properly.

"The Justice Department interceded and as a result there was some redress," Green said. "I hope it doesn't surprise you that earlier today there was a witness from the Justice Department that testified that, but for this Operation Choke Point, that settlement wouldn't have taken place."

Besides pushing to curb Operation Choke Point, bankers also voiced concerns over the treatment of mortgage servicing rights under Basel III, arguing that many community banks keep MSRs after selling the loans to maintain a relationship with local customers. But changes under Basel III could force community banks to sell those rights to nonbanks.

The bankers were supportive of a bill that would require a study to determine appropriate capital requirements for mortgage-servicing assets.

"This is a loss for both the bank, which is no longer able to maintain a long-term relationship with their community, and for the consumers who will see their loan serviced by a third party," R. Daniel Blanton, chief executive of Southeastern Bank Financial in Augusta, Ga., said in prepared remarks.

Blanton noted that 1,500 community banks have "disappeared" in the last decade, making a discussion on supporting smaller institutions an imperative. Even executives at healthy banks "say they are ready to sell to larger banks because the regulatory burden has become too much to manage," he said.

The $270 million-asset First State, which services about 5,700 loans with a total value of $600 million, would lose more than $1.6 million in common equity Tier 1 capital — a 50-basis-point reduction to its ratio — under Basel III rules, Vallandingham said. Rep. Shelley Moore Capito, R-W.Va., asked him to explain the importance of servicing mortgages.

"We would have to change our business model" under Basel III, Vallandingham said. "We could no longer build that portfolio. This would hinder us from continuing to grow."

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