WASHINGTON — Federal Reserve Bank of Kansas City President Thomas Hoenig said community banks likely will continue to be harmed by a perception that larger institutions are "too big to fail."

"Is the community bank model viable? The short answer is, yes. The longer answer is, yes, if they are not put at a competitive disadvantage by policies which favor and subsidize the largest financial institutions," Hoeing said Monday in prepared testimony to a field hearing of the House Subcommittee on Oversight and Investigations.

Hoenig said the recent crisis proved that the largest financial institutions had an advantage in running their business with a higher leverage and lower cost of capital and debt. As a result, regulators took extraordinary actions to ensure smaller banks were not destabilized.

"The advantage of their 'too big to fail' status was highlighted during the crisis, when the [Federal Deposit Insurance Corp.] allowed unlimited insurance on non-interest-bearing checking accounts out of concern that businesses would move their deposits from the smaller to the largest banks," Hoenig said.

Community banks with assets of less than $10 billion account for almost all of the 6,700 banks in the United States. All but three of the 1,100 banks based in the Kansas City Fed district are community banks, Hoenig said.

Even with recent regulatory reforms accomplished under the Dodd-Frank Act to end "too big to fail," investors will still need to be convinced that the government will not bail out large, failing institutions. Until then, community banks will face challenges including higher costs of capital and deposits.

Still, Hoenig said: "There is no better test of the viability of the community bank business model than the financial crisis, recession and abnormally slow recovery that we've experienced over the past two and a half years. The community bank business model has held up well when compared with the megabank model that had to be propped up with taxpayer funding."

Though community banks' earnings were lower last year, they were on par with larger banks' profits. And community banks' lending, rose by about 2%, while lending by larger banks fell 6%, Hoenig noted.

Additionally, business lending by community banks fell 3%, compared with a 21% decline at larger banks.

"Community banks have maintained a strong presence despite industry consolidation because their business model focuses on strong relationships with their customers and local communities," Hoenig said. "Community banks serve all facets of their local economy, including consumers, small businesses, farmers, real estate developers and energy products."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.