Community Banks' Real Problem

POSTED BY ADAM

LEVITIN

Community banks are ailing. Over the past decade many of them have failed or been
gobbled up by larger banks. What's going on?
A new study by a fellow and a masters student at the Harvard Kennedy School of
Government thinks it has found the culprits: Dodd-Frank! The CFPB! Regulation! Not
surprisingly, this paper is already getting circulated by bank lobbyists as a prooftext for their
anti-regulatory agenda.
Let me make no bones about this study. It is gussied up to look like serious academic
research, with footnotes and working paper series cover page, but don't let looks fool you.
The study doesn't conform with basic norms of scholarship, such as discussing contrary
evidence and having conclusions flow from evidence. Instead, the study is really a
mouthpiece for a big bank anti-regulatory agenda that pretends to really be looking out for
community banks.
I'm not going to spend the time on a full-blown Fisking of this piece, but let me point out
some serious problems and then talk about the real problem facing community banks and
how big banks exploit community banks' problems to advance their own agenda.
I. Problems with the Study
A. Ignores Virtually All Contrary Evidence
First, the study doesnt even mention some pretty important contrary evidence:
The Dodd-Frank Act actually gives community banks (which Ill accept for these purposes as
institutions with less than $10B in assets, even though thats pretty big) special treatment.
First, Dodd-Frank exempts community banks from the Durbin Interchange Amendments
debit card fee regulation. That gives community banks a huge competitive boost. Big banks
regulated, community banks not.
Dodd-Frank exempts community banks from examination and enforcement actions by the
CFPB. They are examined and enforced by their regular prudential regulators, unlike the big
banks, so there isnt a dedicated consumer protection agency focused on them.
Dodd-Frank requires the CFPB to go through a special and onerous rule making process for
rules that will affect small business, like community banks. Thats called a SBREFA rulemaking process. It lets small businesses comment on the rules when they are in an early
stage, before the train has left the station, and gives them early intel about the rules. Only
two other federal agencies have to go through the SBREFA process.
The CFPB has built in small bank exceptions to some of its rules, such as a small servicer
exception (which is briefly mentioned) and small lender exception to QM (not mentioned).

The CFPB voluntarily created a community bank advisory board.

A reader would have no idea of the extent of special consideration given to community banks
by Dodd-Frank and the CFPB. Indeed, one could come away from this study thinking that the
CFPB has it in for community banks! In fact, the CFPB is arguably community banks' best
friend in the financial regulatory space. Dodd-Frank has started creating a separate parallel
regulatory track for community banks (something worth considering more deeply, but not
here).
B. Silly Empirics
Second, the study's empirics are laughable. They either show stuff that's been well-known
for years (e.g. importance of community banks in commercial real estate and small business
lending) or make really bad post hoc ergo propter hoc arguments.
The study points to community banks declining market share after the 2d quarter of 2010.
2Q 2010 is chosen as the baseline because that's when Dodd-Frank was enacted. But the
problem is that Dodd-Frank didn't go into effect immediately. The CFPB itself didnt come
into existence for a year, and the CFPB doesnt start rule-makings immediately. The first
CFPB rule makings of note were finalized in January 2013, but did not become effective until
January of 2014! Therefore, it's really hard to blame the decline in community bank's market
share on regulations that weren't in place for most of the period in question.
If one undertakes a slightly more careful analysis, one can see that in the seven quarters since
the CFPB mortgage rules were announced, the market share of community banks with assets
over $1 B actually grows! (Smaller banks' market share shrinks, but at a similar rate to
previous two seven quarter periods).
Market share isnt a meaningful story when market size is changing. One wouldnt know
from this study that community banks assets (all bank sizes) are growing! Not as fast as the
big banks, but they're growing.
Small (<$1B) community banks total assets are shrinking, but thats not necessarily bad. It
might mean that theyre growing and that the biggest small community banks now have over
$1B in assets, so they arent part of the <$1B category any more.
C. Conclusions Don't Follow from Evidence
The third problem with the study is that its conclusions dont follow even from its shoddy
findings. For example, look at the top of page 29, which is a rant about the need to change
CFPBs unilateral directorship structure. What on earth does that have to do with community
banks losing market share? If there's a causal inference, I've missed it. There are reasonable
arguments for changing the structure of the CFPB (I disagree with them, but thats beside the
point). But they are about administrative structure in general. They dont have anything to
do with community banking. And this shows what the study is really about. Its just an
attack on the CFPB.

D. So It's OK to Regulate to Encourage Community Banking, but Not to Protect

Consumers?
The study is fundamentally inconsistent in its approach to regulation. The authors can't
figure out if they like regulation or not. It thinks regulation is killing community banks, but it
hasn't explained why we should care. I think there are good reasons to be concerned about
community banks, but if one is really a free-market believer, there's no reason to favor
community banks over megabanks. They're all businesses and the invisible hand of the
market should decide which ones survive. Once one allows that there should be some state
intervention in industrial policy to favor certain types of businesses, it becomes hard to make
a principled argument against regulation in general. But that's exactly what this study does. It
doesn't complain about particular features of particular regulations, but about too much
regulation.
The problem is never too MUCH regulation. It isn't a quantity issue. It's about the
CONTENT of regulations--do we have bad regulations? This is the constant meme from the
anti-regulatory right: too much regulation, when the problem isn't one of quantity, but quality.
But discussing quality would mean talking about who wins and who loses with particular
regulations, and the anti-regulatory right knows it has a loser of an argument when it comes
to consumer protection, so it refuses to engage in the proper conversation. Instead, it turns
into the Animal House barn: free markets good, regulation ba-a-a-ahd. That doesn't mean I
can't blog it, though. I'm all for encouraging community banking, but not at the expense of
consumers. If community banks don't benefit their communities, it's hard to see why we
should encourage them, and a precondition for benefitting communities is only engaging in
fair, transparent business. If a firm can't compete fairly, it shouldn't be in business.
II. The Real Problem for Community Banks: Size Matters
Instead of this knee-jerk anti-regulatory nonsense, lets be honest about the difficult situation
of community banks. Theres a basic fact of modern consumer finance: size matters.
Size matters in a brutal way in consumer finance, which is a huge business built on lots of
small transactions and has lots of economies of scale. Community banks are, by definition,
unable to leverage economies of scale the way megabanks do. Consider the three largest
consumer finance markets: credit cards, residential mortgages, and deposits & debit cards
(not in that order).
Credit Cards
The credit card business is all about economies of scale: mass marketing solicitation and
intensive data mining and computer security. (I did a study on this several years back for the
Filene Institute, a credit union think tank.) The First State Bank of Smallville just cant
compete in this market. Not surprisingly, many small banks (and credit unions) dont even
offer credit cards, and about 10 banks have 90% of the credit card market.
Residential Mortgages

Mortgages tell a similar story. Mortgage lending is a bad fit for small institutions for four
reasons. First, mortgages, like credit cards, are increasingly technology-driven, both on
underwriting and servicing. The servicing industry is all about economies of scale (and that's
part of its problem). Second, mortgages are large loans, meaning a $100M in mortgages is a
less diversified portfolio simply in terms of number of borrowers than $100M in credit card
receivables. Second, most mortgages are long-term fixed-rate obligations. Small banks cant
handle the interest rate risk of holding large fixed-rate mortgage portfolios, and they dont
want their capital so tied up. So they sell the mortgages to aggregators, who eventually
securitize them via Fannie/Freddie/Ginnie. And that creates the third problem. When
mortgages are sold into the secondary market, they come with representations and warranties
from the originators. Whod you rather have standing behind reps and warrants? A too-bigto-fail bank or a too-small-to-matter bank? The former is money good; the latter looks like a
general unsecured claim in an FDIC receivership.
Community banks are able to compete the commercial mortgage (CRE) market, but it's
because most of the the factors that make them uncompetitive in the residential market aren't
at play. CRE loans are much larger and more unique than residential loans, so there aren't
economies of scale in underwriting and servicing. CRE loans are shorter-term (rarely over 10
years) and more frequently adjustable rate or at least have yield-maintenace clauses to prtect
lenders from rate risk. Moreover, most commercial mortgages aren't securitized, so the rep &
warranty issue isn't there. (CRE securitization deals with properties in only about 60 major
urban markets. The rest is all balance sheet lending.). And for CRE, local knowledge might
matter for underwriting; a community banker is more likely to know the business climate of
his/her community than the personal situation of an individual borrower.
This same story holds true for small-business lending: no economies of scale because of
heterogenous loans, shorter terms so less rate risk, and no securitization (again because its
harder to securitize heterogeneous products). And again, local knowledge might matter for
underwriting.
Deposits and Debit Cards
Deposits and Debit Cards are different, and thats one area where small banks can compete.
Not surprisingly, many more offer debit cards than credit cards. (I explore this in another
study for Filene.) There are some technology and scale pressures on deposits and debit cards,
particularly with the growth of on-line/mobile banking, but they are counterbalanced by
locational factors. A lot of consumers still value having a nearby brick-and-mortar bank
branch. That's what's saving community banks these days.
All of this is to say that size matters in consumer finance, and there's really no way around
that. We can try to put a friendly finger on the scale to help community banks (as detailed
above), but it's unlikely to be a gamechanger.
III. Big Banks Exploit Community Banks' Plight to Push Their Own Deregulatory Agenda

I think on some deep level community bankers know this. But they don't want to admit it
because that would be tantamount to surrender. Instead, it's easier to blame regulation (which
can be changed) than to blame deep structural factors. Dodd-Frank doesn't solve community
banks' problems, but it isn't their cause either. Unfortunately, the community banks' plight is
often exploited by the big banks. Who benefits from an unwinding of CFPB regulations?
Not the community banks--as we've seen, they're barely in the market anymore. It's the big
banks that benefit. Similarly, who would benefit from a less vigorous CFPB, which is what a
committee structure would ensure (look at the SEC's dysfunction as Exhibit A)? Not the
community banks--they're not subject to CFPB exams or enforcement, and they have the
SBREFA rulemaking protection (and are already getting special consideration). It's the big
banks who are pushing for deregulation in the name of helping community banks.
IV. Regulation Is the Community Bank's Best Friend
Regulation is actually the community bank's best friend. Regulation is what is responsible
for community banking in the first place, and it is part of what is sustaining community
banking now. But for things like historic interstate branch banking restrictions, we would
never have a world with nearly 6,000 commercial banks. The US has more banks than any
other country by a couple of orders of magnitude, and it's only because of historical
regulatory restrictions on bigness in banking. But for regulation, there would never have been
more than a handful of community banks. Likewise, FDIC insurance was also a godsend for
small banks. Without FDIC insurance, would anyone put their funds in a small institution
instead of a large one? And even today regulation still protects community banks with things
like merger limitations and entry restrictions. Dodd-Frank has express special regulatory
treatment for community banks in the consumer finance space.
Some community bankers might like to entertain Ayn Randian fantasies and think of
themselves as John Galt, bringing forth the bounty of financial services from the dry earth
solely through their own hard work. If only the government would get out their way and let
them do their business! This is silly. Banking, perhaps more than any other business, is
regulatorily defined and constituted. Let's start with this: you can't open a bank without
regulatory approval, and there's limited competition. Banks don't exist without the
government. That might be an uncomfortable truth for some community bankers, but it's as
true for them as it is for the megabanks: banking is a public-private partnership, and that
comes with certain conditions, not the least of which is that banking must serve the public
good.
Regulation only helps community banks and the communities they exist to serve. Foes of
regulationthis opponents of an orderly, fair, transparent marketplace--are no friends of
community banks and are not friends of the families that rely on them.