Thousands of community banks already have a full plate of concerns maintaining capital levels, working troubled loans, making money and dealing with aggressive regulatory scrutiny. Now they can expect another major burden.
Now regulators are developing "stress tests" to be used by the smallest banks. They said so at a recent meeting of the California Bankers Association, and the Conference of State Bank Supervisors has issued a white paper endorsing the idea.
The government lost control of the financial crisis and hit the panic button in September of 2008, demanding that Congress enact the $700 billion Tarp initiative to purchase toxic assets from Wall Street firms. The ill-conceived program, which never had any chance of calming the crisis, was not implemented and the funds were instead used to purchase capital in hundreds of banks (and nonbanks) whether they wanted or needed it.
Creative programs by the Federal Reserve to inject liquidity into the financial system and by the Federal Deposit Insurance Corp. to guarantee bank and holding company liabilities finally did what Tarp could not do and stabilized the financial system.
In a misguided attempt to bolster confidence, the administration launched the Supervisory Capital Assessment Program in February 2009. This program mandated the stress-testing of the 19 largest financial companies under consistent criteria and economic conditions.
Stress tests can be an important management and supervisory tool if conducted privately. Playing out stress tests in the public arena is foolhardy.
The public announcement of the program rattled the markets causing widespread concerns about which banks would fail the test and what the government would do with them. Bank stock prices and the Dow Jones industrial average plummeted. Chairman Bernanke finally calmed the crisis by declaring in late March that none of the 19 banks would be allowed to fail.
Congress and the administration decided to include annual stress tests in the recent Dodd-Frank Act. We support that for larger banks so long as the tests are conducted privately.
The Dodd-Frank Act wisely excluded from the stress tests banks with assets of less than $10 billion. Unfortunately, the regulators do not seem to be able to resist the urge to impose the burden of stress tests on community banks. It's a classic example of mission creep and one-size-fits-all regulation that is forcing industry consolidation and threatening the long-standing value of community banking.
The stress tests in 2009 were intended to calm the public and insure that major bank failures would not threaten the financial system. It's inconceivable that any number of small bank failures could jeopardize the system. While community banks account for 92% of all banks, they hold just 11% of banking assets. In contrast, the top 19 banks control 82% of banking assets.
Internal stress-testing or considering what-ifs is a good practice for community bank management and boards, but regulatory use of hypothetical stress-test results to determine supervisory ratings and/or required capital levels would be destructive policy.
Community banks should not be subject to a regulatory downgrade as the result of their contemplation of an uncertain future. They should not be forced to sell, consolidate or raise new capital because a test based on hypothetical assumptions suggests that more capital might be necessary to meet possible future eventualities.
Community banks are the heart and soul of thousands of small cities and towns throughout the country. They support civic and community causes and the needs of individuals and small businesses that are important to job creation and local economic stability.
Community banks also happen to be on the endangered species list. Their number has been dwindling rapidly over the past two decades and this trend is not likely to reverse itself without more enlightened regulatory policies.
In 1963 Rep. Wright Patman, the legendary chairman of the House Banking Committee, chided the FDIC for being overly conservative and said that if too few banks were failing, they were not taking enough risk and the economy could not grow. Restrictive policies imposed on banks by the FDIC and the other regulators were stifling the creative instincts of small business.
Somewhere between the conservative policies of the 1950s and early 1960s and the Wild West environment of the past two decades there is a happy middle ground. For the sake of our nation, regulators need to act soon to find the right balance. The use of regulatory-driven stress tests on community banks would not be a positive step toward that end.
William M. Isaac, former chairman of the Federal Deposit Insurance Corp., is global head of financial institutions for FTI Consulting, chairman of Fifth Third Bancorp and author of "Senseless Panic: How Washington Failed America." Robert H. Smith, former chairman and chief executive of Security Pacific Corp., is a founder and director of Commerce National Bank in Newport Beach, Calif.