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Dodd-Frank, aimed at restoring confidence in the so-called Wall Street banks, had a devastating effect on Main Street banks, and is now threatening their long-established role as the backbone of the American Dream.
August 31
The banking system is under pressure — particularly community banks, which have for years been the stalwarts of economic and job growth. Now it appears Washington may just want them out of the way.
Following a two-decade decline to less than half their previous number, the future role and existence of community banks is threatened by regulatory willingness to restrict new charters and accelerated pressure on capital and management.
They are suffering weak demand for loans, credit quality difficulties, growing competition, declining spreads and income sources and rising expenses. Most are today unable to operate with sufficient scale to provide the kind of returns that would attract capital. The result leads one to question the future viability of community banks and expect their continuing decline in number and influence.
By way of reference, the banking system of the United States is composed of the five largest banks that control over 50% of the banking assets; a few hundred regional banks; and more than 6,000 community banks, defined as banks holding less than $1 billion in assets.
The typical community bank's focus is on serving local small or entrepreneurial businesses, small agricultural clients and local individuals in rural areas, small cities and defined communities in large cities and urban areas. Community banks account for 92% of all banks, by number, and nearly 30% of total branch locations, yet hold only 11.5% of total banking assets — down from 26% a quarter century ago.
Since 1990 the nation's small businesses have created nearly three quarters of all the new jobs. Today these businesses collectively employ about half the nation's private sector workers. Their efforts produce 50% of nonfarm real GDP.
About 17.6 million of the 23.3 million active businesses operate independently without payroll employees. Of the remainder, there are 4.6 million companies that operate with 100 employees or less. These two groups are the primary target customers of many community banks. However, competition has muscled in.
In the late 1980s the large banks shunned most small businesses as too risky and costly to serve compared to other opportunities. But over this past two decades, advancing technology, centralized operations and the need to find new areas of profitability have altered their view of this extensive market.
Large banks became aggressively engaged in providing better-priced, technology-based and -aided credit and deposit services to small businesses and farms. During the same period many unregulated businesses — shadow banks — have been formed to provide financial services to small businesses, competitive with what banks offer.
One of the primary vehicles of large bank and shadow bank competition in meeting the needs of the smallest of these businesses has been business credit cards. A 2008 survey by the National Small Business Association found that credit cards were now
As the result of this new competition, growing technology and aggressive regulation many community bank revenue sources have been lost or diminished. These banks have discontinued as too costly, or found reduced demand for numerous noninterest income services. In addition most community banks no longer finance auto dealers, customer cars, or offer consumer or business credit cards. They no longer offer furniture financing plans, or finance business inventory and accounts receivable. In many cases they also collect fewer account service charges, sell fewer checks, and collect fewer loan, return check or overdraft fees. In addition, thanks to competition from money market funds (a subspecies of shadow bank) they no longer benefit from the level of free demand deposits from small-business customers that once amounted to nearly 50% of total business loans.
With fewer small-business and consumer loan opportunities, community banks' revenues and returns on capital have diminished. To overcome these difficulties many community banks changed their focus to financing more lucrative commercial real estate transactions. As a consequence many community banks have experienced self-inflicted troubles because of portfolio concentrations that are experiencing stress and in many cases threatening their viability. While their holdings of commercial and consumer loan assets have declined over the past two decades, the level of portfolio commercial real estate loans increased from 30% to 53% of total community bank assets.
Though a portion of these CRE loans financed owner-occupied small businesses, most recent transactions funded speculative ventures during strong economic times. These changes have permitted sustained asset growth in community banks but, as history has shown, resulted in more failures and an increase in troubled small banks.
From the regulatory perspective, community banks will be required to build higher capital levels under the international Basel standards and are under aggressive regulatory scrutiny resulting from thousands of pages of new regulations, including those emanating from Dodd-Frank. The impact has been reduced leverage and increased expenses to maintain regulatory compliance.
Politicians and senior regulators consistently and publically profess the value and importance of community banks to our economy, yet their recent actions suggest otherwise. The flood of new regulation, demands for more capital, harsh enforcement plus an unexplained three-year-old de facto moratorium on de novo bank charters lead one to believe that Washington really wants fewer community banks.
Why else would these aggressive actions be taking place? The authorities seem to be moving toward a universe of fewer and larger banks, even though such changes harm many local communities and their economies.
They most likely see the changes in the community bank business model that have taken place over the past 20 years. They are not happy with the level of community bank failures or a continuing large number of troubled small banks. They are well aware of how small businesses now meet much of their banking needs through large or shadow banks with better-priced or more flexible credit and financial services. They also see the risks of a continued focus on commercial real estate loans and the community banks' limited alternatives to maintain a meaningful return of capital.
In the final analysis it seems clear that Washington wants and sees a smaller, stronger banking industry. Given the facts and recent experience it's hard to argue otherwise and there seems to be nothing that will alter this direction.
Robert H. Smith, the former chairman and chief executive of Security Pacific Corp., is a founder and director of Commerce National Bank in Newport Beach, Calif.
