What Matthew Yglesias Should Have Said About Small Banks

In a much maligned Dec. 2 blog post entitled "America's Microbank Problem," Slate's business and economics correspondent Matthew Yglesias claimed that, even with all the banks that have merged or closed, the U.S. still has too many banks: 6,891 by his count. In his opinion, most are tiny, not especially well-run, and tough to regulate. He'd prefer to see the total number of banks be in the dozens rather than the thousands.

This brief, 600-word article has created quite a stir among those in or around the banking business. American Banker has already run two rebuttals.

The publication's Washington bureau chief, Rob Blackwell, wrote the first one on Dec. 3. He pointed out that 515 banks are on the Federal Deposit Insurance Corp.'s "problem bank" list, just a "sliver" of the overall number of institutions. Also, the vast majority of community banks survived the financial crisis, which nearly defeated many of "the best and the brightest" (a phrase Yglesias used with a sarcasm that his detractors seem to have missed). And Blackwell thinks that small banks are in fact easier to regulate. AB Community Banking Editor Paul Davis' article on Dec. 6 gave examples of how specific community banks showed commitments to their communities and strove to innovate, and posited that such commitment and innovation would disappear if all the little banks were gobbled up or closed.

Those who follow banks know that the U.S. has so many of them because of its history, not by choices made in today's modern economy. Like the QWERTY keyboard on my computer, the U.S. banking system was designed for another time, and it's hard to argue that if we were to design either today from scratch that we'd choose what we have.

Of course, we can't redesign the system from scratch. Does it matter that today's system offends Yglesias' sensibilities? That depends. If a community decides to form a bank to serve the needs of local businesses and consumers (or if their descendants decide to keep such a bank intact over the years), they should have the right to do so, even if that means we end up with lots of banks. And the owners are under no obligation to sell if the bank isn't all that profitable; value maximization isn't necessarily a goal.

Fine. But the fact is that the lion's share of banking assets are held by publicly traded banks, not private ones. They exist to earn their shareholders – most of whom have no personal attachment to the banks' communities – an attractive return. There are currently over 900 publicly traded banks and thrifts with a market capitalization over $10 million. These banks have $12.4 trillion in assets and $1.4 trillion in market cap. Yes, the four largest make up 54% of aggregate market cap, but that still leaves 46%.

The disparity of operating performance across these smaller banks is astounding. Intentionally or not, Blackwell muddles this very important point. Twenty percent of those 900 or so institutions have returns on average tangible common equity over 12.3%. Five percent are over 17.2%. The bottom 30% post returns below 5.7%. Is 5.7% acceptable? Perhaps it doesn't look horrible in absolute terms in today's ultra-low interest rate environment, but it is horrible any way you cut it.

Bank CEOs are competitive people. Some think of themselves the way athletes do, made better through intense competition. But in sporting events, there are clear winners and losers, because there are rules as well as a clear definition of what "winning" is. Consistent losers eventually depart the field.

Is that true in banking? Some weak banks do the same things that strong banks do, but seemingly without understanding why. They undertake acquisitions, but they pay too much, fail to deliver on deal promises, and yet remain convinced of their own prowess. They are willing to discuss a sale, but they hold out for prices unwarranted given their operating performance. They repurchase shares, but without regard to buyback price and with the hope that it will signal optimism, generate EPS growth or improve ROE. Better times are always just around the corner. If only the yield curve weren't lousy, or regulatory compliance costs or consumer uncertainty so high. Or whatever. It's a skill to be able to bend reality to serve your purposes.

It would be a shame if the self-righteous indignation some bankers and their lobbyists appear to be displaying in the wake of Yglesias' imprecise article distracted from these very real issues. The time has come for bank stock investors and public bank CEOs to agree on how to define success, and what should (and just as importantly, shouldn't) happen if it doesn't materialize.

Who will take the first step?

Harvard Winters, a former investment banker, writes research on banks.