Is Dodd-Frank Killing Community Banks? The More Important Question is How to Save Them

Arguments have emerged from all sections of the banking spectrum concerning the causes of community banks' decline. Many observers argue that Dodd Frank's regulations disproportionately impact community banks. But there is no consensus on this. In this morning's American Banker, banking industry consultant and investor J.V. Rizzi takes the opposite view. "There are many things to dislike about the Dodd-Frank Act," he writes. "Causing the demise of community banks, however, is not one of them." Rizzi correctly points out that "the number of community banks with assets under $100 million dropped from 13,000 in 1995 to 2,625 in 2010--before Dodd-Frank was enacted. The number of small community banks had dropped under 1,900 by 2014."

But Forbes contributing writer Carrie Sheffield takes the opposite view in an article published in February. Sheffield admits that community bank decline began before Dodd-Frank, but adds: "while the number of community banks already declined before the crisis, since the second quarter of 2010--Dodd-Frank's passage--community banks have lost market share at a rate double what they did between Q2 2006 and Q2 2010: 12 percent vs. 6 percent." Research by the Harvard Kennedy School of Government supports Sheffield's assertion, and provides the causal link Rizzi says does not exist. The research, by Marshall Lux and Robert Green, concludes that, while there are certainly other factors (technology driving consolidation, the financial advantage enjoyed by big banks), "Dodd-Frank has exacerbated the preexisting trend of banking consolidation by piling up regulatory costs on institutions that neither pose systemic risks nor have the diversified businesses to support such costs . . . Our findings appear to validate concerns that an increasingly complex and uncoordinated regulatory system has created an uneven regulatory playing field that is accellerating consolidation for the wrong reasons."

Regulatory economies of scale, as the GAO has shown, drive consolidation: "larger banks are better suited to handle heightened regulatory burdens than are smaller banks, causing the average costs of community banks to be higher," Lux and Green write. The authors interviewed Community Control, a regulatory compliance firm, which reported that Dodd-Frank necessitated heightened costs in compliance with truth-in-lending, real estate settlement procedures, capital planning, and stress test requirements that substantially increased compliance costs for community banks. While it is easy to say "well, all banks should comply with increased regulations to avoid another 2008 disaster," the fact remains that small banks did not cause that crisis, and there is little evidence to suggest that too-big-to-fail banks will change their ways even under Dodd-Frank and other new regulations. Rizzi blames economies of scale in general, rather than regulatory economies of scale, for the decline in community banks. But this seems to at least partially concede that regulations affect big and small banks differently. When combined with the argument that the small banks did not deserve the regulatory burdens they received, we're left with a near-concession that the Dodd-Frank critics are right.

Rizzi has more arguments to answer. Another specific way in which Dodd-Frank threatens the financial base of community banks is its new rules that toughen up mortgage qualifications and ability-to-repay standards. For the majority of community banks, home mortgage loans are their main source of revenue. Seventy three percent of such banks say regulations are hurting their lending.

In his December 30 American Banker article, Akshat Tewary raises the provocative point that community bankers are on the losing end of big banks' lobbying and manipulation of cumbersome banking regulations. Dodd-Frank originally included Section 716, a rule requiring large banks to move "risky swap activities from insured depository institutions to nonbank affiliates" so that such risky activities would not receive government support such as federal deposit insurance. The recent congressional budget bill repealed most of Section 716. Although "the amendment to Section 716 serves as little more than a public subsidy to a handful of big banks," remarkably, smaller banks, including what we call "community banks" pushed for the repeal, even though they were neither harmed by 716's original implementation nor helped by its repeal. "Similarly, many community banks have lobbied against the Volcker Rule even though that law, by its own terms, has greatly relaxed compliance and record-keeping requirements for smaller banks. It actually makes community banks more competitive against their larger competitors."

For Tewary, community banks are like the 99 percent, semi-consciously working to prop up the 1%. This has serious implications for a business—banking—that pretends to operate by free market principles and instead functions as an example of crony socialism.  For supporters of public banking, it's both a challenge and an opportunity to bring community banks on board with a model that we already know works to help smaller banks succeed while bypassing Wall Street.

Still more evidence emerges of the disproportionate impact of regulations:

community financial institutions saw a 26 percent increase in the number of hours and employees required to meet regulatory compliance demands in the third quarter, according to the latest Banking Compliance Index (BCI), compiled and analyzed by Continuity Control, a New Haven, Conn.-based provider of a compliance management system for community financial institutions. The latest BCI found that the average community bank needed to devote 653 additional hours, or the equivalent of 1.86 full-time employees, to manage the 82 new regulatory changes added in the third quarter. To meet those needs, the average institution had to spend an additional $45,264 on compliance last quarter, according to Continuity Control.

So it appears that, regardless of Rizzi's assertions of alternate causality, there is a widespread perception (we can argue until the cows come home as to its accuracy) that regulatory burdens are exacerbating, if not causing, the rapid decline in community banks.

Why is this important? Here are seven reasons:

1. “Community banks focus attention on the needs of local families and businesses.”
2. “Community banks use local deposits to make loans to the neighborhoods where their depositors live and work.”
3. “Community bank officers are generally accessible to their customers on site with decisions on loans being made locally.”
4. “Community bank employees are typically deeply involved in local community affairs.”
5. “Community banks are willing to consider important attributes such as a person’s character when making loans.”
6. “Community banks are themselves small businesses, so they understand the needs of small business owners.”
7. “Community banks’ boards of directors are made up of local citizens who want to advance the interests of the towns and cities where they live and the bank does business.”

Those concerned with municipal budgets (since cities and counties are the first line of response in meeting the needs of all citizens, particularly those who are struggling financially), should take special note of how Community banks uniquely fund municipalities. Ivy M. Washington and William T. Wisser of the Federal Reserve Bank of Philadelphia released Q2 analysis last year concluding:

Community banking organizations will continue to remain a vital source of funding for municipalities for the foreseeable future, and the Federal Reserve encourages banks to make loans to creditworthy individual and institutional borrowers. As some municipalities continue to struggle financially, however, and with additional bankruptcy petitions possible, the view that municipal lending is a low-risk lending activity may be debatable. Municipal lending can be a profitable activity that meets the financing needs of the communities in which banks operate, but banks should ensure that they have an effective risk management program in place to address risks and regulatory concerns related to municipal lending.

Public banks offer unique benefits to community banks, including collateralization of deposits, protection from poaching of customers by big banks, the creation of more successful deals, and, important in light of what we've discussed above, regulatory compliance. The Bank of North Dakota, the nation's only public bank, directly supports community banks and enables them to meet regulatory requirements such as asset to loan rations and deposit to loan ratios. It makes shareholder loans to investors in those banks allowing those banks to increase their capital when needed and it can make deposits into those banks to increase their deposit base. On top of all that, it keeps community banks solvent in other ways, lessening the impact of regulatory compliance on banks' bottom lines.

We know from FDIC data in 2009 that North Dakota had almost 16 banks per 100,000 people, the most in the country. A more important figure, however, is community banks’ loan averages per capita, which was $12,000 in North Dakota, compared to only $3,000 nationally. Number of overall loans is also a significant figure, because having more banks doesn’t necessarily mean providing more loans, particularly when it’s difficult for small businesses to get them. During the last decade, banks in North Dakota with less than $1 billion in assets have averaged a stunning 434 percent more small business lending  than the national average.

Short–term projections show North Dakota will suffer significantly less decline than the national average. According to the Minneapolis Federal Reserve, North Dakota may lose two banks to consolidation in 2015, but the nation as a whole will lose 317 such banks, an average of 6.34 per state. The pressure on community banks is tough right now, and North Dakota banks won't emerge completely unscathed, but its rate of loss in 2015 will be less than a third of the national average.

Obviously regulatory burdens are important factors in the survivability of small banks. Congress should re-shape legislation like Dodd-Frank to be friendlier to community banks. But the most constructive step towards the health of community banks --and, in turn, the financial health of local communities and states-- would be to open one or more public banks in every state. Citizens across the country know that, which is why they are demanding such banks in Hawaii, Washington, Colorado, Arizona, New Mexico, Illinois, Pennsylvania, New Hampshire, Maine, Connecticut and more. Causation is indeed complex, but the case for public banks is simple, and North Dakota repeatedly demonstrates that the case is sound.

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