How to keep community banks thriving

By Raphael Bostic and Michael Johnson

The United States today has nearly 5,000 community banks, which is more than the number of banks of any size in any country in the world.

But this fact belies a stark reality. Between 1990 and 2018, the number of banks with assets less than $500 million declined by about 70%, representing a loss of about 7,600 institutions.

Some of this decline is due to banks growing above the $500 million threshold.

Consolidation has been another factor. Technological advances, competitive pressures, regulatory issues, including compliance costs and other forces, have fueled a wave of bank mergers. And the Great Recession was particularly tough for the smallest banking institutions.

Given this shrinkage in the number of community banks (with up to $10 billion in assets) — particularly the smallest ones — a key question is: Does it matter?

We at the Atlanta Fed think it does.

Community banks bring truly unique benefits to the communities where they operate, particularly in rural areas and underserved urban neighborhoods. Small, locally based institutions have always been vital to small business, agricultural and consumer lending.

Nearly half of small businesses that sought outside financing in the second half of 2018 approached community banks, and 65% of those businesses did so based on an existing relationship, according to the Federal Reserve’s 2019 Small Business Credit Survey: Report on Employer Firms.

Further, deep local knowledge and relationship-based lending can stem losses during downturns as community bankers work closely with borrowers to avoid defaults. Simply put, community-based lenders stick with their borrowers in tough times.

Moreover, community banks are often pillars of the broader communities in which they operate through their support of civic organizations and local institutions like Little League.

In sum, I agree with my colleague, Kansas City Fed President Esther George, who recently observed that community banks are generally best situated to understand local conditions, needs and opportunities.

Finally, the Federal Reserve supports community banks as a core element of a stable financial system. “Our system is made more resilient through a broad and varied range of institutions serving different types of customers, with community banks providing access to credit and other financial services in towns and cities across America,” Fed Gov. Michelle W. Bowman said in an October speech.

That said, it is important to recognize that community banks vary in many respects. For simplicity, let’s break them into two categories: rural community banks and urban community banks.

While they share important traits, institutions in these two categories serve different purposes and face different challenges.

Consider rural community banks. As vital sources of financial services and capital, they are truly anchors of their communities. Without these banks, the very viability of rural communities could be threatened.

But from a performance perspective, there is some good news. Fed data show that rural community banks generally have outperformed their urban counterparts. They even maintained positive average return-on-assets and return-on-equity ratios through the Great Recession.

Still, as Fed Gov. Randal Quarles has pointed out, even if the data says most rural markets are well served, attention must be focused on the places that may not be as well served. And there needs to be a deeper understanding of how that deficit affects the people who bank, or cannot bank, there. Beneath the aggregate numbers lies wide variation in the experiences of individual markets.

Delving a bit deeper, in the six states of the Sixth Federal Reserve District, nearly a third of 223 rural counties had three or fewer banking offices at the end of 2018. (The District includes all or parts of Alabama, Florida, Georgia, Louisiana, Mississippi and Tennessee.)

Losing a rural community bank also means losing financial advice and local civic leadership. And it represents the loss of an anchor that attracts people who can become customers for businesses near the bank. When people drive to a different town to visit their bank, they are more likely to eat and shop there than in the town where the bank closed.

While they exhibit similarities to their rural counterparts, urban community banks fill a different though equally important niche. They often serve populations that might otherwise have few options for mainstream financial services. Certainly, urban areas offer other banking options, but many residents do not view those options as desirable.

Minority-owned banks are a good example. The Kansas City Fed recently published a book documenting the origins of African-American-owned banks. That volume highlights the special bonds of trust those institutions shared with customers in the time when race-based discrimination was widespread.

These bonds were important in bringing into the banking system many African-American families who otherwise might have turned to riskier alternatives for financial services. Those early African-American-owned banks played a pivotal role in the fight for economic independence and opportunity, and urban community banks broadly play that role today.

So what can be done to preserve the vitality of the community banking system?

If we believe that the place one lives should not determine access to opportunity, then it would seem that preserving and maintaining the viability of community banks should be a priority.

A remedy often heard is regulatory relief, and the Fed has been responsive to this call. In recent years, the Fed, in partnership with other banking regulatory agencies, has tailored its supervisory expectations based on risk, reduced capital complexity and reporting requirements. And it has expanded eligibility for longer exam cycles, all of which have reduced regulatory burden for smaller banks.

Regulatory relief is important, and more is possible. But it is no panacea for these institutions.

By some measures, the cost of regulatory compliance has receded as a top concern of community bankers. In the 2019 community bank survey by the Conference of State Bank Supervisors, only 4% of banks ranked regulation as the factor most likely to influence profitability, down from 60% two years earlier.

This decline is partly explained by the regulatory relief that has already been implemented. Among 571 banks in the survey, aggregate compliance costs declined $500 million from 2016 to 2018.

So what other measures could help shore up the community bank sector? We’ll offer a couple of suggestions that we believe merit consideration.

First, establishing a funding source that rural community banks could tap to build and nurture their talent base and infrastructure would address two of the most pressing issues many community banks face.

In particular, recruiting management talent and building out sophisticated technological systems are often challenging for rural institutions. Such a vehicle might be analogous to the Community Development Financial Institutions Fund. Call it the Community Bank Fund.

Where would the money come from? Larger banks could receive Community Reinvestment Act credit for investing in the fund. Support could also come from nonprofit and philanthropic organizations that recognize the critical role of community banks, especially in rural economic development.

Secondly, consortia of banks and banking industry organizations could pool resources to create a shared organization that would perform all the regulatory compliance and other nonproprietary back-office work for its members. The specialization would reduce costs for community banks and free resources for the provision of important banking services.

Clearly, community banks face difficult challenges. But the industry and regulatory agencies can devise creative ways to give them a hand up. Community banks are cornerstones of communities across the nation. Whatever the price of helping to secure their future, the price of losing them would be much greater.