Industry Watch

The Incredible Shrinking Community Bank

Is the regulatory burden killing small banks?

Friday, September 18, 2015

In banking, numbers tell the story. If so, these numbers have the making of a tragedy: In 2000 there were 513 community banks in Minnesota. Now we have 332, a drop of 35% in just 15 years. What’s going on?  There are two factors at play according to Joe Witt, president of the Minnesota Bankers Association. One is increased competition from large players like Wal-Mart entering the financial services industry and from tax-exempt organizations like credit unions. “Right off the top they’ve got a 30% or 40% operating cost advantage,” says Witt.

But the dominant factor that is causing small banks to sell out or close shop is what Witt calls the “cumulative effect” of government regulations.

A steady stream of regs

In 1970 banks were recruited into law enforcement with the Bank Secrecy Act, which required them to watch out for possible money laundering by drug dealers or racketeers. This law enforcement role was augmented after 9/11 when banks were drafted into the anti-terrorist effort. But that’s not all.

Since 2000, more than a dozen major laws and regulations affecting banks have been passed. Aside from the anti-terrorist rules these included the Know Your Customer Law, changes in privacy notices, Community Reinvestment Act, Truth in Lending requirements, higher capital standards, and higher requirements for IT security. These were all unfunded mandates, which meant it cost the banks time and money to comply.

During this time there has been a steady decline in the number of bank charters across the United States and throughout Minnesota. This occurred even though there was a steady stream of new bank charters.

This drab picture took a turn for the worse when the Great Recession hit in 2007/2008.

The dreaded Dodd-Frank

The complicity of the major Wall Street financial institutions in the financial crisis prompted one of the largest financial reform acts in U.S. history, the Dodd-Frank Wall Street Reform and Consumer Protection Act. It aimed to avoid further economic turmoil by creating more oversight, accountability and transparency in the financial world. It was signed into law in 2010.

One purpose of Dodd-Frank was to reform mortgage rules, but those rules are aimed at large mortgage brokers that originate loans and immediately sell them off. Those brokers have nothing to lose if the loan is good or bad, because they get paid either way. Once they sell the loan, it isn’t their problem anymore.

When community banks originate loans, they usually keep the loan. The bank is invested in that loan. The rules were created to avoid bad loans, but small banks are forced to avoid bad loans simply by virtue of being a small bank. A bad loan is bad for business, and if a bank is small enough, taking a large hit on a loan that will never be repaid can be catastrophic.

“We were opposed to how Dodd-Frank approached regulation,” Witt says. “We felt there were ways to regulate the bad practices without pounding the people who weren’t doing it wrong in the first place.”
The problem with adding regulation isn’t that small banks can’t adhere to the standards, it’s that they simply can’t keep up.

“We are getting paddled and beaten in terms of additional compliance responsibilities,” says Bill Patient, vice president of compliance at BankCherokee in St. Paul. “Everyone is in the same playing field and working with the same regulations.”

Patient says that beyond just the sheer pages of new documents, the hardest part for small banks is spending time to understand new rules and regulations. Compliance officers must sort through the new laws to figure out what they mean, how the rules work with current regulations and which rules apply to their institution. Many small banks have no compliance officers on staff, and the increased workload can be devastating for small institutions.

Accelerated decline

The 10 years before Dodd-Frank went into effect, Minnesota was losing as many as 3.2% of its community banks each year, with most years being 2% or less. But in the five years since Dodd-Frank was passed, in four years the decrease was greater than 4%. Bank charters in Minnesota have been disappearing fast since this latest piece of legislation. To make matters worse, no new charters have come along in our state since 2007.

More and more community banks are closing shop, and research shows that when a bank closes, it is almost always sold to another institution. This means that the loss isn’t in brick and mortar banks, but rather banks that community members have come to know.

Losing community banks isn’t simply about less choice for consumers. In rural communities, the local bank can be the lifeblood of the town, and being a small town bank might not be worthwhile anymore, says David Reiling, president of Sunrise Banks in Minneapolis. “There’s a lot more risk and the return may be uncertain at best.”

Community banks likely won’t go extinct, but it’s hard to imagine the numbers climbing any time soon. “It sounds sappy,” Reiling says, “but bankers just aren’t having fun anymore. There is so much bureaucracy and so many boxes to check, even in regards to customers you’ve had for 20 years, that there is little room to practice the craft of banking.”

Legislative Relief

As these small institutions continue to shut down, the Minnesota Bankers Association is supporting national legislation that will help community banks. In Congress in June Representative Scott Tipton (R-Colo.) introduced the Tailor Act. As its name suggests, the law would allow flexibility in regulations so that they could be tailored toward specific banks. One size does not fit all.

Under the bill, there would be different regulations depending on products offered. This would take the pressure off smaller institutions by only requiring regulations that apply directly to their line of business. Minnesota Representative Tom Emmer, who sits on the House Financial Services Committee, is one of 22 co-signers of the bill.

It remains to be seen the extent to which the bill would provide relief from the burden of compliance. Several years ago Witt sent a letter outlining his concerns to the Federal Deposit Insurance Corporation. In the letter he quoted a banker who said, ”We used to do banking in compliance with the laws and regulations. Now we do compliance and hope that it allows us to do some banking.”