Time for a Separate Regulatory Tier for Small Banks

Community banks are being crushed by a vise of higher costs and lower revenues, and their every move is watched by examiners determined not to get blamed for the next crisis.

They are being told to beef up capital and compliance and forsake overdraft and interchange fee income. The lousy economy pounds salt into these wounds. Banks are shrinking just to stay alive — or they are giving up and selling out.

The number of banks has already been cut in half, to roughly 7,000, and it's no stretch to imagine that total being halved again in coming years.

The question for policymakers is does this matter? And if it does, what should officials be doing today to prevent that tomorrow?

For a lot of readers the answer to the first question is as obvious as apple pie and motherhood. Community banks are the lifeblood of their local markets and should be nurtured, if not protected.

But with the proliferation of places to get and stash cash, it's not as obvious to others who argue the market — not the government — should decide whether community banks live or die.

The question is suddenly getting a lot of attention as policymakers obsess over how to rev up the economy enough to spur job creation. Federal Reserve Board Chairman Ben Bernanke made a point of highlighting the importance of community banks as a source of small-business funding during Senate testimony this month.

"We want to make sure we do all we can not to increase the regulatory burden that small banks face," Bernanke said. "Small banks have been playing just an incredibly important role, particularly as large banks have cut back on their lending to small business."

The Fed and the Federal Deposit Insurance Corp. hosted a daylong conference Jan. 13 to identify the hurdles facing small-business finance. The FDIC set up a hot line for small businesses to call if they think a too-tough examiner is the reason behind their loan denial. This is a way around the frequent complaint that bankers do not challenge examiners for fear of reprisal. Borrowers can do it for them.

At that conference, in his first speech as House Financial Services Committee Chairman, Rep. Spencer Bachus made it clear where he stands.

"Some examiners are micromanaging the daily activities at community banks," the Alabama Republican said. "All of us in Washington … must continue to examine the mixed messages being sent to community banks which continue to create uncertainty and impede recovery."

Bachus dedicated the committee's first hearing Wednesday "to review roadblocks that small businesses and community banks are facing."

The biggest roadblock is regulation.

According to interviews with community bankers and the people who represent them at state and national associations, there is too much of it and it's being applied too harshly to small banks.

Here are three examples collected while reporting this story: a young examiner cited a bank for depreciating the cost of wallpaper too slowly; suspicious when a bank filed no currency transaction reports, an examiner conducted a three-day Bank Secrecy Act exam; an examiner cited a bank for getting a flood certification one day after closing a loan (the bank has never had a loan loss due to flooding).

"We've got to make regulation simpler. We've got to make it less expensive. We've got to make it less threatening," said Max Cook, president and CEO of the Missouri Bankers Association.

Many community bankers said their examiner, once a trusted adviser who helped the bank operate better, is now more concerned with defending his or her performance to superiors in Washington.

For both bankers and their examiners, judgment is being trumped by box-checking. Some bankers actually empathize with their examiners. As one put it, "It's pity to see them relegated to the role of paper shufflers."

The solution is to overhaul the way community banks are supervised.

One option would be moving away from a "rules-based" to a "principles-based" approach to supervising banks with assets of less than, say, $1 billion. Rather than policing compliance with detailed rules, examiners could simply assess the bank's operations. Does senior management have a firm handle on the risks the bank is taking? Is it operating safely? Is it meeting the community's needs?

Some bankers suggested creating an agency that does nothing but oversee community banks. A dedicated force of seasoned examiners could visit once a year and look at everything instead of coming back repeatedly for multiple, separate looks at consumer compliance, money laundering, information systems, etc. Exam reports would be delivered quickly, not languish at headquarters for months, and consistency would be the norm. If the facts behind a loan didn't change, then neither would its rating.

Robert R. Jones 3rd, the president and CEO of United Bank in Atmore, Ala., said regulation should be scaled to match a bank's business model.

"Let's accept that there are differences in the complexity of the business models and have risk-appropriate governance based on those business models," he said. "It's not just one size fits all."

A former high-ranking regulator agreed.

"There ought to be two different regimes of supervision for big and small. The level of skill to regulate them effectively is vastly different."

He added: "Community banks and the small regional banks are going to be the lifeblood of the resurgence in small-business lending. No question about it. That hasn't happened yet. And it won't happen if bankers are paranoid about getting their brains beat in by examiners."

William B. Grant, the chairman, president and CEO of First Bank & Trust in Oakland, Md., said extending the time frame for complying with the Dodd-Frank Act over seven or eight years would be a huge help. "Let's do this in bite-sized pieces," he said. "Focus on one or two topics a year rather than this tsunami."

Capital is another sore point with a lot of community bankers. They realize it is hard to argue against higher capital levels considering what's gone on the last two years, but community bankers say examiners are looking for a minimum of 9% capital, up from 7%. Raising that extra capital is, if not impossible, exhausting.

"There is a real fatigue setting in, in just trying to figure out how to keep up with all this stuff," one banker said. "Because it's hard to raise capital, instead you adjust your balance sheet."

That's a nice way of saying community banks are boosting their capital ratios by shrinking. That hardly feeds economic growth.

The trend toward plain-vanilla banking products also has community bankers on edge. Their trump card is the ability to give customers something they can't get at a larger institution — products and services tailored to their specific circumstances.

"The problem now is they are getting crushed by government regulation and by restrictions on their flexibility to prudently use their biggest asset: high-touch responsiveness to the local area," said Mike Van Buskirk, president and CEO of the Ohio Bankers League.

Community bank advocates also want policymakers to address the other end of the size spectrum.

"I think the Congress should seriously look at what unbridled concentration is doing to the banking industry and to the infrastructure of small-town America," said Cam Fine, president and CEO of the Independent Community Bankers of America. "They should impose severe restrictions on any further growth and consolidation within the industry."

Fine suggested the existing cap barring any bank from expanding through acquisition once it controls 10% of the nation's deposits be whittled to 5%. "That would force these institutions to divest, to become more regional and more responsive to local communities," he said.

Finally, community bankers want to be able to compete equally with other providers of financial services, and many hope the new Consumer Financial Protection Bureau will manage to level the field. And of course, community banks want credit unions, at least the large ones, to pay taxes.

"We need the government hand to be even," Van Buskirk said. "So whoever serves the customer best wins, not who has the lowest government-imposed cost of doing business."

Community banks are disappearing for a lot of reasons, including rural depopulation, technological advances and a slow economy. But regulatory mandates are also driving consolidation, and to counter that force community bankers are arguing for streamlined oversight, steady capital levels, the ability to customize products, a curb on industry concentration and equal treatment for all providers.

Without such changes, the industry's community banking segment could shrivel. And while customers will still have plenty of access to financial services, communities will suffer and people with quirky credit needs, including lots of small businesses, will have a harder time getting financing.

"A bank closer to the customer will be able to safely make loans on the margin when you are talking about a startup or a growing small business," Van Buskirk said. "Those are ones that often fall in gray areas, where the scoring model from 1,000 miles away might say 'no,' but the knowledge that the local banker has might lead to a 'yes.' "

Jones, the banker from Alabama, echoed many of his counterparts when he said that community bankers are deeply involved in their towns, running the chamber of commerce, serving on the school board, raising money for United Way, sponsoring Little League teams, and so much else.

"A lot of intangibles come with our presence," Jones said. "Your ability to make an economic impact has a multiplier effect, and that is a difficult thing to quantify.

"But I know we make a difference."