What If 99% of Banks Disappeared?

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I shudder to imagine a U.S. economic future where Slate's Matt Yglesias got his wish and 99% of existing banks were eliminated.

A system where only the top 1% of existing banks are deemed worthy to remain in business sounds like a grim sci-fi movie. Gone would be a ton of lending, along with people who have shown leadership in times of crisis. We'd also lose a significant number of innovators.

As my colleague Rob Blackwell has passionately stated already, most small banks are well-run, profitable and easier to regulate compared with the large banks that have complex financial instruments and nearly incomprehensible off-balance-sheet dealings.

But what the customer, and the economy, would lose must be considered, too. Data and personal experience demonstrate that it would be quite a lot – and not easily replaced.

Community banks provide a substantial amount of credit to startups that would otherwise go overlooked by larger institutions. A large part of this is because community bankers know the people in their communities and they are plugged into the markets that they serve. They also have more flexibility to lend based on so-called soft information, which can overcome the opaque nature of many applicants.

Data back this up. Smith Williams and Yan Lee, researchers at the Federal Deposit Insurance Corp., presented a white paper at the Federal Reserve Board's first community bank research conference that supports the notion that small banks are the primary source of startup funding.

Williams and Lee studied nearly 3,000 startup businesses, looking at their proximity to community banks and how they are financed. They found that startups become less likely to fund operations with bank loans as the distance between their office and a community bank increases.

Startups that do not borrow from banks usually resort to using credit cards to pay their initial bills. The researchers found that instances of using credit cards rose by 7% for every quarter mile of distance between the startup and the closest community bank.

"Proximity to the nearest community bank does affect the likelihood of new firms using bank credit," Williams said during her presentation at the Fed. "New firms that locate further away from community banks are more likely to use expensive, and impersonal, credit cards."

Credit cards have higher rates and less forgiving terms, which could cripple or destroy a startup before it even hits the ground running. The FDIC's researchers observed that firm deaths eliminate 40% of the jobs created by startups within the first five years.

That's not to say that community bankers are blindly rubber-stamping every application that crosses their desk. Some might take on excessive risk, but most are doing everything they can to secure terms and conditions to protect their investment – and they are willing to turn away business plans that exceed their risk tolerance.

That point was made recently by Frank Gavigan, chief executive at Premier Commercial Bank in Greensboro, N.C., during a presentation to local business leaders. He told attendees that the bank wants to lend to entrepreneurs, though it must be mindful of risk. "If you are a career nurse looking to, say, go out and open a beauty salon with no proven track record, we may not be the bank for you," he said.

Data aside, there are countless examples of small banks that are connecting with their communities. And, under the plan promoted by Yglesias, those connections would be snuffed out if the government put all of those banks out of business.

Premier Commercial, for instance, hosts monthly sessions with local businesses, bringing in outside professionals to discuss emerging topics ranging from succession planning to health care reform. Just last month, they hosted a local economist to give attendees a glimpse at the area's challenges and opportunities in 2014.

In St. Louis, Enterprise Financial (EFSC) offers "Enterprise University" -- free courses in areas such as marketing, social media, employee compensation and business valuation. These are half-day courses led by working professionals. Attendees do not have to be bank customers, though management certainly hopes they can change that.

Those opportunities would be limited, or gone, if Yglesias were in charge of bank regulation.

In terms of crisis management, look no further than Gulf Coast bankers during the vicious hurricanes of 2005.

Employees of Hancock Holding in Gulfport, Miss., washed, dried and ironed cash that was flooded by Hurricane Katrina, then set up tables in the community to make loans with little, to no, documentation from borrowers. Rusty Cloutier, CEO of MidSouth Bancorp in Metairie, La., drove $500,000 in cash to Beaumont, Texas, to pay city workers after Hurricane Rita.

Emergency funds like those might be harder to come by if all community banks disappeared.

And a number of community banks are innovators, even if they don't command big headlines in magazines like Slate.

In addition to being one of the nation's most-prolific SBA lenders, Live Oak Bank in Wilmington, N.C., built an app that transfers the bulk of the paper-intensive lending process online, making it more efficient, more accessible and easier to manage. Today, nCino helps other banks manage commercial and construction loans, and plans are under way to expand into retail and mortgage lending.

Just a few hundred miles inland, Independence Bancshares in Greenville, S.C., is developing an app that seeks to tie together mobile banking and real-time processing technology. Management, including former Citigroup execs, hope to hold a trial run next year.

Sure, a number of innovators may stumble but at least they are out there trying to develop new solutions to benefit bankers and their customers. Those efforts would cease to exist if Yglesias got his wish.

I agree that a number of banks are still limping along because of unresolved credit issues, regulatory costs, and so on. The vast majority of the community bankers who neglected to "mind the store," as Yglesias puts it, disappeared when their banks failed. And we have market conditions in place to start paring the ranks of the small banks that cannot stay competitive, though would-be buyers remain understandably cautious. That, too, will change.

I was talking to a community banker in North Carolina recently, who expressed that thought. Pressley Ridgill, CEO of NewBridge Bancorp in Greensboro, told me he believes that mergers among the state's biggest community banks make sense, though executives must set aside ego-driven obstacles, such as who gets to be the boss and whose brand name will survive.

Still, Ridgill is convinced that those types of deals will happen, pointing to a recent acquisition by the former SCBT in South Carolina and Union First Market's pending acquisition of StellarOne in Virginia as examples. Those types of transactions will take root in other states which, in turn, will shrink the number of community banks.

More importantly, they will preserve an integral subset of banking that will continue to make loans, educate customers and innovate.

Paul Davis is Community Banking Editor at American Banker

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Community banking Law and regulation