OCTOBER 7, 2010
Banks Can Drive an Economic Recovery. No, Not Those Banks
By DAVID WEIDNER Wall Street Journal
As regulators huddle to interpret the new financial-overhaul law, the grousing from the big banks is growing louder.
Squeeze us with new regulations, capital requirements and compliance costs and you can kiss an economic recovery good bye, says the Financial Services Roundtable. We won't be able to extend credit to small businesses and individuals.
And you know what? They have a point.
Only it isn't the big banks that will curtail lending. Even without new rules they are still not lending at a rate that economists say is needed for a recovery. It is the small, community banks that will suffer. And like smaller businesses in the broader economy, community banks are the key to getting the economic engines firing.
In the aftermath of the financial crisis and the bailouts, the banking industry has become more polarized. Four banks control a combined $7.34 trillion in assets and $3.57 trillion in deposits—56% and 39% of all U.S. assets and deposits respectively, according to SNL Financial.
The rest is scattered about nearly 7,800 banks and nearly as many credit unions. Yet, those roughly 15,000 institutions must succumb to the bulk of the Dodd-Frank Act's changes. Compliance costs have tripled for those smaller banks, according to Louis Hernandez Jr., chief executive of Open Solutions Inc., a bank technology-consulting firm.
In a new book, "Too Small To Fail: How the Financial Industry Crisis Changed the World's Perceptions," Mr. Hernandez argues against the axioms of bigger-is-better banking. Small banks, despite the 829 banks on the Federal Deposit Insurance Corp.'s problem bank list, are generally in good shape even though the vast majority of them didn't ask, take or qualify for bailout funds.
Small banks actually have emerged from the crisis with their balance sheets in good shape. They are poised to lend and capitalize on their bigger competitors troubles.
They are not doing so, though, in large part because these banks are being asked to pay for the sins of their bigger cousins. They have had to pony up future premiums to keep the FDIC's insurance fund solvent. And now they are being asked to add to their compliance costs by tackling onerous paperwork and scouring their loans for potential trouble.
While that may seem like a good idea, consider that the vast majority of smaller banks already do this before they even make the loan. That is because unlike the Citigroups and Bank of Americas of the world, they hold most of their loans on the books to maturity. It is what the industry calls relationship banking and it is pretty much the way all banking was done before massive consolidation made it impractical and Wall Street got in the game.
For a big bank that never examined its loan portfolio, a requirement to do so now makes a lot of sense. For a small bank, it is onerous and costly, Mr. Hernandez argues.
"They're catching the shrapnel postcrisis," he said. "It's making it harder to do what they do best."
As a result, many community banks are hanging it up. They are selling out to bigger rivals. Mr. Hernandez estimates that in the next three to five years, 2,500 community banks will disappear and 1,000 to 1,500 credit unions will close or consolidate if costs don't come down.
There is no replacement either. Bank applications have dwindled post-financial crisis. The FDIC approved 1,219 bank applications during the decade, but only two this year.
In the current regulatory environment "it's really impossible to start a new bank unless you raise a substantial amount of cash," Mr. Hernandez said.
The dwindling number of banks serving small communities is being felt especially hard in the West and Northeast where community banks control just 11% of assets, according to the Community Bankers Association. In those regions, a lack of competition or incentive to lend is putting the brakes on growth.
Without community banks, small businesses and individuals in those regions must depend on the national and regional banks for credit. Big banks may be lending more—J.P. Morgan Chase & Co., for instance, has a goal to lend $10 billion to small business—but the one-size-fits-all credit standards employed by national banks remains a high hurdle for many borrowers.
That gap used to be filled by the community bank, which unlike their bigger banking cousins, who are beholden to shareholders, are invested in the communities they serve. Americans like smaller banks too. Community banks have higher retention rates.
The solution, Mr. Hernandez says, requires action by both regulators and the banks themselves. Regulators including the FDIC and the new consumer agency need to become sensitive to the impact of rule-making for small institutions. Small banks need to become more efficient and share the cost of upgrading their systems. They also need to promote themselves as a healthy alternative to big banking, something Mr. Hernandez said they have failed to do.
In many ways, Washington in addressing the problems of big banking has given those banks an advantage. Financial overhaul is geared toward big institutions with expensive internal controls. For them, the costs of the changes are cheaper per loan than small banks.
Breaking up the banks, a plan promoted by Simon Johnson, Robert Reich and Arnold Kling, among others, would have created an even playing field and made banking a more even playing field and benefited consumers.
But the opportunity for that idea has passed. We are stuck in a world where big banks set the course for the industry, and the smaller banks are forced to pay the price for their transgressions. Yes, the banking industry has changed since the financial crisis.
It has become bigger and less competitive.
Write to David Weidner at email@example.com