When I entered community banking 29 years ago, bank regulation was focused on two things: The accuracy of financial reports in the bank’s call report, and the bank’s ability to detect and guard against insiders stealing money from the institution.
Back in 1988, the banking industry was still expanding. The number of banks and savings and loans, as well as that for credit unions, was each around 20,000 — and growing every year. The call reports in July 1988 were about 10 pages long versus the over 100 pages our community bank must file today. Some community banks now get to use a “short” form, which runs 80 pages.
The focus of bank regulation today is completely different. Its goal is to ensure that banks don't fail. To achieve this objective, banks must establish committees and follow best practices and complete a lot of documentation of their every move. I met with a customer the other day. It was only the fourth such meeting I have had within the past 12 months. Bank executives have become desk-bound, engaged in constant box-checking and “administrivia.” As expected, this new reality has raised regulatory costs.
Another key factor driving regulatory costs higher is a philosophy that detailed legal disclosures are beneficial to consumers — as best exemplified by mortgage disclosures that now stack six to nine inches high — yet these documents are expensive to create and in the real world consumers don’t actually read them. Yet, to comply and produce all these complicated disclosures, institutions must establish and maintain very expensive systems, much of which have fixed costs and only some are variable in cost.
Because of these rising regulatory and compliance disclosure costs, the median return on equity for FDIC-insured banks in the U.S. has fallen to 9%; there are many banks under $100 million in assets with an ROE below 4%. Since the financial markets require a 9% ROE for investment in bank equity, half the banks in the U.S. are now worth more dead than alive, making them ripe for merger. On average, both one credit union and one bank are sold each business day. The peak of roughly 20,000 banks has fallen to below 5,800.
Why are these low-profit banks and credit unions desirable merger or acquisition candidates? Each regulation has costs that are relatively fixed. For example, if a regulation costs $100,000 a year for a bank to comply and that bank has 1,000,000 transactions, the cost comes to $0.10 per transaction. If a bank has 1,000 transactions, the cost is $100 per transaction. The larger bank can buy the business of the smaller bank, take out the second set of regulatory costs and substantially increase the profit per transaction of the combined bank. To be able to succeed in such an environment banks must seek ever larger volumes of business and achieve economies of scale.
Under this scenario, any regulation is good for the business model of large or acquisition-focused banks and credit unions. To be clear, the number of institutions in the industry was on the decline before the passage of the Dodd-Frank Act in 2010, but that trend continued following implementation of the regulatory reform law. The law supposedly targeted the biggest financial firms, which had brought the economy to its knees with their risky activities, but just look at the response by Goldman Sachs CEO Lloyd Blankfein when he was questioned about the effect the then-still-pending legislation: “We will be among the biggest beneficiaries of reform.”
The current regulatory policy and philosophy drives the growth of ever-larger, harder-to-manage and harder-to-regulate megabanks, while community banks have been left to be picked up by acquirers. Unless those policies change, that trend will persist for President Trump’s entire term in office. Assuming President Trump wins reelection, by the time he would leave office in 2025, there would be only 2,000 banks and 2,000 credit unions left. By then it would be too late to rescue the community banking industry in the U.S.
A policy designed to ensure that banks don’t fail which actually just helps along the failure of 75% of banks and credit unions, is obviously not successful and therefore must be changed.
While it is a laudatory goal to want banks to be so well-run and able to control risks that none fail, in the real world this is a clear policy failure. The system that encouraged the growth of the industry for decades also fostered growth in the number of banks and credit unions. Access to credit from a diverse array of sources at the grassroots level is a strong positive social good and key to the success of the American economy.
Centralizing credit among a few powerful megabanks is not just risky. It’s bad for our economy and slows economic growth rates. It also threatens our democracy over the long term, since money can translate into power and trillion-dollar pools of money can easily warp the political process. While banks and credit unions routinely failed under the old system, more new ones always sprung up and took their place. This cycle of creative destruction was healthy for a dynamic economy.
For large systemically important institutions, preventing failure perhaps makes more sense, and the full scale of current regulation and best practices for the biggest companies is appropriate. However if we want to foster a community banking and community credit union industry in the U.S., we need to radically rethink our regulatory approach.