It is widely acknowledged that community banks provide the majority of loans to our nation's small businesses and serve as an important financial resource to small towns and rural communities. It is not widely discussed, however, that community banks collectively make our financial system safer. As a significant factor contributing to industry consolidation, new laws and regulations designed to enhance safety and soundness are actually heightening systemic risk.
The statistics showing industry contraction are undeniable. As regulatory burden has grown, the number of institutions has dropped more than 60% over the last 25 years.
The cost of regulatory compliance has both a fixed and a variable component. Increasing variable costs lowers returns, impeding the ability of the entire industry to attract, let alone retain, capital. As fixed costs rise, so does the size threshold for viability, leaving smaller banks no choice but to get out. And then there is the talent component. Excessive, duplicative and even inconsistent regulation reinforces the impression that the term "banker" is more akin to a dirty word than a respected profession. And the biggest insult of all is that Main Street bankers are being punished for crimes they did not commit. Community banks were not to blame for the financial crisis, nor do they have a history of taking advantage of consumers, people who are the community banker's neighbors and friends.
So how is this making the banking system less stable? Fundamental insurance and investment principles explain why.
The Federal Deposit Insurance Corp. is in the insurance business and the primary business of insurance is loss predictability. And since the law of large numbers teaches us that predictability is directly related to the size of the population, the fewer the number of banks, the more likely it is that the FDIC's insurance fund might not be adequate to cover the losses.
Think about it this way: If we only had one $10 trillion bank covered by the FDIC and it had a 1% chance of failure each year and that failure would cost $1 trillion, the fund would theoretically need to have $10 billion. Let's double that to $20 billion just to be safe. Each year the bank did not fail, no problem. Unfortunately, if it were to fail, the fund would be $980 billion short. If, however, there were 10,000 banks, all with $1 billion and the same risk profile, the FDIC would likely need $10 billion to cover its annual loss. With $20 billion in reserve, we can all be much more confident the insurance fund won't go underwater and taxpayers won't be called upon for a bailout.
Loss avoidance is not necessarily inconsistent with loss predictability, but when rules designed to avoid losses materially reduce the size of the insured population, the risk of a potentially catastrophic loss goes up. This is what happens when a greater proportion of institutions are too big to fail.
The second hidden danger of too much regulation is that it decreases the differences between banks. As regulation has increased, banks have become more homogeneous.
The most basic investment strategy designed to maximize risk-adjusted returns over time is diversification. With the exception of geographic diversity, simply having more banks that are otherwise identical erodes some of the protection afforded by the law of large numbers.
An investor enjoys some diversification by owning stock in a variety of companies. Real diversification, however, is only created by investing in the widest variety of companies, industries and asset classes as is reasonably possible. Regulation that results in excessive similarities between banks not only decays the diversity that reduces risk, but it also diminishes the likelihood that innovations will be developed to reduce the remaining risks.
The evidence is clear that the level of bank regulation has reached the point of increasing the risks it was intended to reduce. Basic insurance and investment management principles support the case for community bank deregulation. Public policy ignores those principles at our collective economic peril.
Joe B. Slavens is president and chief executive of Northwest Bank & Trust Co. in Davenport, Iowa.