The community banking model has worked for many years. For many, the model continues to work. But for others, it needs an overhaul given accelerating compliance costs and burdens and tech advancements.
According to the Independent Community Bankers of America, community banks represent 14% of banking assets in the United States. And yet, they make about 46% of small loans to farms and businesses – a key component to creating jobs and a vibrant economy. Furthermore, community banks hold the majority of banking deposits outside of large cities. For residents of 600 rural or micropolitan counties, community banks are the only banks that serve them.
But there are also hundreds of community banks – often located in small towns – that are unprofitable or barely profitable. These small banks cannot fully serve their communities because of their difficulty or inability to attract capital coupled with their increasing compliance burdens and limited resources.
It's time for some small banks to consider merging with marketplace lenders in appropriate circumstances.
Marketplace lending partnerships could expand a community bank's geographical reach to customers anywhere. The partnerships can also let banks offer customers new financial products and deliver those products in new ways, and potentially put them in a better position to attract capital and better afford escalating compliance costs.
Expansion of community banks' geographic scope and product mix in a responsible way would make the institutions safer and sounder by offering diversification. During and after the Great Recession, many of the banks that failed were community banks whose loans were concentrated in their local communities. If a bank's community suffered disproportionately in the economic and real estate downturn (for example, communities in Georgia and Florida), so did the institution. Had their loans been more geographically dispersed, they might have survived. A more diversified mix of loan types may also have diminished risk associated with commercial real estate concentrations that are common among community banks and those that failed in the crisis.
At the same time, marketplace lenders are discovering that it may not be ideal for them to operate without a bank charter. Some of these fintech companies are finding that funding sources may not be reliable and profitability may be elusive. Furthermore, those with a national presence face different sets of laws and regulations, including interest rate caps, in every state.
One alternative for marketplace lenders would be to form de novo banks. Marketplace lenders can do that under current law and regulations, but until the Office of the Comptroller of the Currency clarifies intentions around creating a limited-purpose charter, they won't be able to form de novo institutions that lack federal deposit insurance. That is a subject for another day, but suffice it to say that regulatory processes for forming a de novo bank may be considerably lengthier with less certain results.
For marketplace lenders dissatisfied with their current model, doing business as a bank – by merging with a bank – would allow them to offer FDIC-insured deposits, including core deposits, to support their lending operations. The partnerships would also let marketplace lenders face a simplified set of laws and regulations.
Mergers of marketplace lenders and banks are not, however, without their pitfalls.
Wall Street valuations of marketplace lenders are currently substantially greater than they are for banks. Marketplace lenders that merge with banks can expect at least a temporary hit to their valuations.
There may also be culture clashes between traditional bankers and the entrepreneurs that populate marketplace lenders. Compensation models may also vary dramatically.
As banks, marketplace lenders would experience rigorous examinations by the federal banking agencies and become subject to their enforcement powers. Furthermore, the application process may not be easy, in part because of possible sentiments among some at the federal banking agencies that "once a community bank, always a community bank." But community bank and marketplace lender mergers won't necessarily diminish the service rendered to the community. Indeed, marketplace lending has the potential to help support and expand community banking services.
The regulatory agencies may also have concerns with concentrations, reliance on noncore deposits, liquidity and management issues, among other things. Regulators may be tempted to impose stringent conditions on approvals such as high capital requirements or perpetual operating agreements (where the bank would be required to obtain approval for any material deviation from its three-year business plan until the agency decided to lift the agreement). But the agencies may also realize that overly strict conditions such as a perpetual operating agreement may dissuade qualified parties from pursuing a community bank/marketplace lender merger. Higher capital requirements and other regulatory requirements could work in favor of those marketplace lenders that qualify by bringing more validation for their industry while keeping competitors that cannot meet the requirements out of the banking system.
The bottom line is these mergers could help some community banks and marketplace lenders that may be better off becoming banks.
David Baris is partner at BuckleySandler and president of the American Association of Bank Directors.