« Sh*t In, Sh*t Out? the Problem of Mortgage Data Corruption & Empirical Analysis | Main | Consumer Bankruptcy Circles the Globe »

Size Matters: 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 doesn’t even mention some pretty important contrary evidence: 

  • The Dodd-Frank Act actually gives community banks (which I’ll accept for these purposes as institutions with less than $10B in assets, even though that’s pretty big) special treatment.
    • First, Dodd-Frank exempts community banks from the Durbin Interchange Amendment’s 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 isn’t 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.  That’s called a SBREFA rule-making 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 didn’t come into existence for a year, and the CFPB doesn’t 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 isn’t a meaningful story when market size is changing.  One wouldn’t 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 that’s not necessarily bad.  It might mean that they’re growing and that the biggest small community banks now have over $1B in assets, so they aren’t part of the <$1B category any more.  

C.  Conclusions Don't Follow from Evidence

The third problem with the study is that its conclusions don’t follow even from its shoddy findings. For example, look at the top of page 29, which is a rant about the need to change CFPB’s 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 that’s beside the point).  But they are about administrative structure in general.  They don’t have anything to do with community banking.  And this shows what the study is really about.  It’s 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, let’s be honest about the difficult situation of community banks.  There’s 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 can’t compete in this market.  Not surprisingly, many small banks (and credit unions) don’t 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 can’t handle the interest rate risk of holding large fixed-rate mortgage portfolios, and they don’t 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.  Who’d you rather have standing behind reps and warrants?  A too-big-to-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 that’s 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 regulation—this opponents of an orderly, fair, transparent marketplace--are no friends of community banks and are not friends of the families that rely on them.



I think you mean the Animal Farm barn, not the Animal House barn -- unless you're thinking of a more awesome version the story I'm unaware of.

Agreed on most points, but the proper survey period for market policy reaction isn't always the policy roll out calendar. If you model any sort of rational expectations, then the market adjusts to prior to the roll out.

Alex: there's no plausible rational expectations story here. Assets aren't going to move from community banks to big banks unless a change in service/pricing is announced, and it's hard to see community banks doing an anticipatory pricing change, as that would only drive away market share sooner.

Dodd-Frank provided some benefits to TBTF. For example, unlimited FDIC protection may have been broadly applied, but the justification for its enactment validated the TBTF thesis. A firm might view TBTF deposit protection as a permanent feature. If that view is broadly anticipated, then, for the same pricing, TBTF deposit currency increases in value relative to smaller banks.

This piece is about 60% correct, but just to take one example of the incorrect, the author asks why we should care about the survival of small banks. I'm not sure of his stance, though he implies that free market advocates should not distinguish between large and small financial institutions for regulatory purposes. Here are 2 reasons for distinguishing: (1) you cannot have a game without rules and umpires and at some point there is no game, no market -- remember Too Big to Fail? It is bigger now. (2) with increasing size comes increasing distance from the population served. Do you know of anyone who tried to reach the mortgage holding financial institution during the recent crisis? A good number of these foreclosures need not have happened if the mortgage holder would only have talked to the borrower. That is just one example. Size matters.

Thanks for sharing this post with us. It will help us more.

Credit Profile Numbers

The major problem from the author's point of view is that he lacks understanding of rural markets. Obviously he only wants to dwell on the plight of city dwellers. Urban America has the TBTF banks. City dwellers don't seem to mind if they pay exhorbant fees for their banking services...and also the lack of security (apparently). TBTF's have a distinct cost of funding advantage that reduces their cost significantly. Where's the offset to community banking? Lastly, TBTF's don't and will not supply much needed credit to rural America, especially to homeowners in rural markets for their financing. Look at the data, who supplies most of the small business credit, its not the big boys. Community banks in our country meet this need.

@Slightright. Rural markets are different, but the CFPB exempts rural lenders from the escrow requirement for high-cost mortgage loans. The CFPB is currently proposing expanding the definition of rural such that it should include 4,100 instead of 2,400 lenders. Most of those lenders are already maintain escrow accounts, however. They are also mainly already exempt from parts of the QM regulation's by virtue of being "small creditors".

The comments to this entry are closed.


Current Guests

Follow Us On Twitter

Like Us on Facebook

  • Like Us on Facebook

    By "Liking" us on Facebook, you will receive excerpts of our posts in your Facebook news feed. (If you change your mind, you can undo it later.) Note that this is different than "Liking" our Facebook page, although a "Like" in either place will get you Credit Slips post on your Facebook news feed.

News Feed



  • As a public service, the University of Illinois College of Law operates Bankr-L, an e-mail list on which bankruptcy professionals can exchange information. Bankr-L is administered by one of the Credit Slips bloggers, Professor Robert M. Lawless of the University of Illinois. Although Bankr-L is a free service, membership is limited only to persons with a professional connection to the bankruptcy field (e.g., lawyer, accountant, academic, judge). To request a subscription on Bankr-L, click here to visit the page for the list and then click on the link for "Subscribe." After completing the information there, please also send an e-mail to Professor Lawless (rlawless@illinois.edu) with a short description of your professional connection to bankruptcy. A link to a URL with a professional bio or other identifying information would be great.