Malcolm Holland, president of $650 million Veritex Community Bank in Dallas, Texas, worries about the future of community banks as a result of increasing federal regulations and growing compliance costs. His concern is based upon the increasing expansion of federal rules that limit the flexibility of community bankers to meet the needs of their customers: “Community banks need to be creative because small business is creative. If we can’t meet the needs of small business – the core of our business – the economy as we’ve known it will cease to exist.”
In Mr. Holland’s opinion, legislators and regulators have failed to distinguish traditional community banks from the large multinational finance corporations commonly called “banks,” but for whom the standard functions of banking – taking deposits and making loans – are a minuscule part of their activities. It was the activities of the too-big-to-fail entities that caused the recent worldwide financial crisis, not the community banks. Unfortunately, in response to the mortgage securities debacle and in their efforts to prevent similar abuses in the future, the heavy hands of the regulators and uninformed legislators have unnecessarily and unfairly burdened community banks.
History of Community Banks
Banking is among the oldest industries in the world, tracing its roots back to ancient times where lenders, representing temples of worship or ancient rulers, provided loans to farmers to raise crops or traders to finance purchases in a distant region. As government-issued currencies became more acceptable and common, commerce expanded across continents and oceans, and a greater proportion of the population began to rise above subsistence, the beginning of our modern banking system appeared.
The first regulated savings bank in America (and the world) was the Provident Institution for Savings of Boston, Massachusetts in 1816. Just as the ballot box provided the opportunity for a man to assert himself in the politics of the nation, the savings banks allowed him to share in its prosperity, according to John Townsend, writing in his 1896 “The History of Savings-Banks in The United States.” It is from these roots that community-based financing developed.
Definition of Community-Based Financing
Simply stated, community-based financing is the utilization of locally based and supported financial institutions and organizations to fund local businesses and individuals within the same community or geographic area. The concept implies a continuous cycle where residents of the community, employed by and trading with local businesses, deposit their savings in locally owned institutions, which subsequently (and repeatedly) lend to or invest in local businesses and individuals.
For example, the Federal Depositor Insurance Corporation (FDIC) in a December 2012 study defined a “community bank” as a bank which has specialized knowledge of their local community and customers and “base credit decisions on local knowledge and nonstandard obtained through long-term relationships”; they obtain most of their deposits locally and make many (if not the majority) of their loans to local businesses. The FDIC considers such banks particularly important to small businesses.
While banks are not the only source of community financing, they are the most visible. According to FDIC statistics, community banks represent 92.4% of all banks while controlling 14.2% of total bank assets (2010 data). Banks with less than $500 million in deposits represent more than 80% of all banks. Community banks provide almost one-half of small-business loans, more than 40% of farm loans, and more than one-third of commercial real estate loans.
Speaking before the House Subcommittee on Financial Institutions and Consumer Credit of the committee on financial services during the first session of the 112th Congress in 2011, Marty Reinhart, president of the $100 million Heritage Bank in Spencer, Wisconsin, best summarized the community bank model, saying, “Community banks serve rural, small town, and suburban customers and markets that are not comprehensively served by large banks [and are] based on longstanding relationships in the communities in which we live…A community banker’s personal knowledge of the community and the borrower provides firsthand insight into the true quality of a loan, in stark contrast to the statistical model used by large banks.”
The Benefits of a Vibrant Community Bank System
A vibrant community bank system benefits the country and its citizens in numerous ways:
- Aligning Interest Rates to Community Needs. Many community financing organizations aggressively seek deposits by paying higher interest rates to savers than those paid by national firms with access to capital across the country and the world. While the market for local deposits may be finite, the accompanying administrative and marketing costs necessary to exploit a local market is considerably less than the expense required to support a national financial behemoth in multiple markets.
- Providing a Greater Sense of Security. As the last financial crisis proved, local financial companies are less likely to participate in high-risk transactions such as derivatives and other exotic investments. Furthermore, the ability to “reach out and touch one’s assets” – actually knowing the identity of borrowers or seeing tangible evidence of where the funds are being utilized and the result of their usage – is less stressful psychologically than owning a intangible asset whose short-term value is dominated by rumor and speculation.
- Local Economic Stability. A community with a diverse group of vibrant local companies is more stable, financially robust, and less susceptible to economic turmoil than a community served by a single employer or large national chain operations. When investors keep their money in local financial institutions that invest in local businesses and people, they are insulated to some extent from events outside the community.
- Providing Funds Based on Nontraditional Criteria. Local investors typically decide to invest or loan money using nontraditional criteria in addition to standard investment underwriting. Knowing the history and reputation of borrowers and their importance to the community is likely a better indicator of repayment than credit reports, ratios, and uncertain pro forma statements. Smaller companies are likely to find community sources more receptive to investment than large bureaucratic lenders and investors who rely on strict procedures to make financial decisions.
- Increasing the Sense of Community. Community-based banks are generally invested in their borrowers to a greater degree than most national lenders, and may provide substantial assistance through advice and contacts that national banks often lack. Being familiar with its borrowers’ products, services, and operations, a local banker can assist its customers to identify local suppliers and markets that they may have overlooked. Relying on a community banker while serving local residents strengthen community ties and may result in additional customers and clients who prefer to deal with community entities.
How Dodd-Frank Regulations Threaten the Viability of Community Banks
In 2008, American residential markets collapsed. This coupled with ongoing scandals in subprime mortgage lending, mortgage securitization, and the explosive growth of exotic (and poorly understood) financial derivatives led to a worldwide recession that continues to reverberate today.
As a consequence, the United States Congress passed sweeping legislation and intensified regulatory oversight to avoid a similar event in the future. Yet community bankers played no role in the following events and actions that shaped the crisis:
- Subprime Mortgage Lending Debacle. The default rate for total residential mortgages held by community banks was 0.2% from January 2003 to September 2012. In fact, residential mortgage defaults held by community banks was only 2% of all defaults, making them a “very minor player” in the subprime lending market on absolute and relative levels.
- Securitization Abuses. Community banks participated in less than 0.1% of the total residential mortgage securitization activities between 2003 and 2010 with minuscule income from fees; by contrast, non-community banks received 8% of their non-interest income from securitization activities.
- Risky Derivative Trades. While some community banks (11%) do use interest rate swaps – a form of derivatives – to hedge interest rate risk or provide services to customers, most do not. Furthermore, the interest rate swap is incomparable to the exotic, often inexplicable versions of derivatives used at the large banks. According to FDIC data, community banks held just 0.003% of all credit derivatives held by banking institutions between 2003 and 2010.
Despite the evidence that they were not responsible for the banking system failure and that no community bank was a threat to the financial system overall, Congress, in the belief that the American banking system was broken, painted every institution with the same broad brush when it passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, the most comprehensive reform of the financial industry since the mid-1930s passage of the various Securities Acts.
While laudable in intent, like most government regulations, legislators failed to do the following:
- Differentiate between the various segments of the finance industry
- Recognize the role or lack thereof each segment played in the creation or escalation of the crisis
- Understand the possible unintended consequences of the sweeping legislation upon the system as a whole and particularly the community banks
Speaking to the Subcommittee on Economic Growth, Tax and Capital Access of the House Committee on Small Business June 16, 2011, Thomas P. Boyle, vice chairman of the State Bank of Countryside in Countryside, Illinois, asserted that additional regulatory costs, second-guessing by bank examiners, and expected new rules and regulations are “slowly and surely strangling traditional community banks, handicapping our ability to meet the credit needs of our communities…Costs are rising, access to capital is limited, and revenues sources have been severely cut. It means fewer loans get made. It means a weaker economy. It means slower job growth.”
According to The Wall Street Journal, Shelter Insurance – the majority owners of Shelter Financial Bank, a $200 million community bank in Columbia, Missouri – closed the bank in September 2012 in anticipation of the impact of additional regulatory costs. “[Additional regulatory expenses were] going to cost more than what we got out of the bank,” stated Joe Moseley, Shelter Insurance’s vice president of public affairs.
Standardization Adversely Affects Competition
In their efforts to improve financial stability and consumer protection, legislators have inadvertently favored big banks, the culprits of the recent failure, over their community bank rivals. In their effort to improve customer understanding, Dodd-Frank imposes a standardization of financial products and forms such as the strict ability-to-repay requirement for home mortgages. However, as a consequence, many consumers (especially small businesses, minorities, and first-time borrowers) will lose their access to banking products, being unable to conform to inflexible rules and regulations.
Speaking before the House Committee on Oversight and Government Reform on July 18,2013, senior research fellow at the Mercatus Center of George Mason University Hester Pierce stated, “The needs of homogenous consumers can be met with homogeneous products, but the assumption that consumers are homogeneous is wrong. Community banks’ practice of getting to know their customers and tailoring products to their needs is at odds with the Dodd-Frank version of consumer protection.”
Community banks have always emphasized relationship banking, personalized underwriting, and customization of financial products to meet the specific needs of the community they serve. As such, residential mortgage lending may be particularly affected.
The standard practice of community banks has been to make mortgage loans and retain them until maturity or earlier repayment; they sell mortgage loans at a much smaller rate than larger financial institutions, which predominately package them into mortgage securities. Essentially, community banks bear the risk that their borrower may fail to repay the loan and their track record of low default proves their lending model is appropriate for them. The requirement to use “qualified mortgages” – effectively standardizing residential mortgages – limits the community banker’s ability to recognize unique circumstances through customer-specific underwriting.
Standardization also favors the large over the small since most of the costs to advertise, sell, and service similar banking products and services are fixed. For example, the cost of designing and coding an information system to comply with new regulations is essentially the same whether you are handling 2,000 loans or 200,000 loans, but the administrative cost per loan is drastically different depending upon scale. The inability to customize products and services always gives the largest player an advantage. Consumers, all of whom must meet the same borrower standards, will naturally go to the lowest-cost provider, the large bank. Effectively, Dodd-Frank, while intending to eliminate the too-big-to-fail mentality, has instead encouraged unrestrained growth.
Left unchanged, the requirement to standardize financial products will limit community banks to those markets too small to interest the big banks and consequently force them into mergers or extinction. In an article for American Banker, J.V. Rizzi, banking consultant and an instructor at DePaul University in Chicago, writes that regulatory changes in the industry’s cost structure has resulted in major structural changes for the banking industry, especially at the community bank level: “The changes affect the economic viability of the community banking model for institutions lacking sufficient scale.”
Disproportionate Impact of Regulatory Compliance
The impact of the costs associated with compliance with the new Dodd-Frank regulations affects the two segments of the banking industry differently, even as new regulations and interpretations continue. While identifying the direct and indirect costs of compliance is difficult for small banks that generally have a limited number of personnel with overlapping duties, the anecdotal evidence of the compliance burden is evident from testimony delivered before the House Subcommittee on Financial Institutions and Consumer Credit in 2011:
- The Pecos Country State Bank in Texas compliance manual has grown from 100 pages in 1986 to more than 1,000 pages today, requiring a full-time compliance officer and a real estate clerk to keep abreast of changes.
- Lester Leonidas Parker, president of a $177 million minority-owned bank in El Paso, Texas, testified that his compliance staff had grown from 10% of employees to over 25% in the last four or five years, exceeding the growth of the bank, its loans, investments, or deposits.
- Greg Ohlendorf, president of $150 million First community Bank and Trust in Beecher, Illinois was more succinct: “What we have to understand is we’re already overburdened with regulation…the consistent piling on of additional regulations is very, very stunning. It’s punishing.”
At the same time, Jamie Dimon, Chairman of JPMorgan Chase, estimated that their cost to comply would be approximately $3 billion over the next few years. This is the bank that lost $6.25 billion in 2012 by the action of a single unsupervised derivative trader. When questioned by analysts about the large loss, Dimon referred to the matter as a “complete tempest in a teapot,” apparently insignificant since Chase has a “big portfolio” and is a “large company.” Despite that loss, Chase reported record net income of $21.3 billion on revenues of $99.9 billion. For perspective, consider that the median American bank has $165 million in assets.
Need for Two-Tiered Regulatory System
Tanya March, Professor of Law at the Wake Forest University School of Law and Adjunct Scholar at the American Enterprise Institute, and Joseph Norman, MBA and graduate of Wake Forest University School of Law, have created five proposals to save community banks:
- Narrow Banking. The essence of the proposal is to tightly limit the activities in which banks can engage to traditional activities such as deposit taking, lending, fiduciary services, and other activities closely related to traditional banking. This would require the large, complex institutions to spin off their traditional banking units or segregate them from investment banking activities such as securities trading and underwriting.
- Limit Standardization. In other words, let the banks who bear the risk underwrite their own loans while preserving necessary consumer protections.
- Eliminate the Dual Banking System. In reality, there is currently much overlap between the state and national regulations, increasing regulatory costs and lack of supervisory coordination. Some believe that a single regulatory approach to banking would simplify oversight and reduce costs.
- Transfer Consumer Protection Regulation to the States. Federal regulation favors the large banks that need consistency to manage their large multi-state operations, while community banks typically operate in a single state. There is some question whether federal consumer protection laws are as effective as state regulations. Finally, there is little evidence that community banks engage in predatory lending or other anti-consumer practices that might require federal oversight beyond the current regulations.
- Resize Bank Examinations. If there are concerns about the safety or soundness of banks, a better approach would be to raise capital reserve requirements for banks, thereby adding a cushion of equity to protect depositors and the public at large. Maintaining higher reserves would eliminate the need for intrusive and expensive (for both parties) examinations.
The single regulatory approach to banking fails to recognize the fundamental differences between community banks and the large, often multinational financial behemoths that dominate American’s economy. At the same time, community banks are critical to the small business community and those citizens who do not fit into the one-size-fits-all regulatory model now in place.
Whether small towns or neighborhoods within a greater urban areas, communities have always occupied a special place in the American psyche. The image of a tight-knit community where neighbors know each other and people seem to be happy is an ideal reflected in Andy Griffith’s Mayberry RFD and Bedford Falls, New York where George Bailey is a dedicated local building and loan association manager (in “It’s a Wonderful Life”).
Fortunately, there is more truth than myth in the stereotype – people do live in small communities, even within big cities, and care about their neighbors. We need to make the effort to save our community banks. Whether you are seeking a place to invest or need funds to build your business, your first source should be your local community bank. And don’t forget to let your legislative representative know how you feel – the community you save is the one in which you live.