Do Regulators Hate Small Banks?


Although the title may be a bit inflammatory, questioning the future of community banking seems to be gaining popularity.  An example is this article in the Raddon Report called "Reading Between the Line Items."  The article notes the decline in both the number of smaller banks and the market share of those remaining small banks:

The balance sheets of smaller firms (defined as those institutions with less than $100 million of assets and those firms with between $100 million and $1 billion of assets) continue to shrink. As it stands, smaller firms, which represent 91-percent of all FDIC-insured institutions, hold only ten percent of industry assets. They held thirteen percent of industry assets in 2006. In contrast, larger firms, which represent only one percent of all FDIC-insured institutions, now hold seventy-nine percent of bank industry assets. [2]
The attrition rate of big banks versus smaller institutions is also out of balance. Since 2006, smaller institutions have left the industry at a considerably higher rate than their larger peers. There are 8,681 FDIC-insured institutions, 13-percent or 1,168 have gone by the wayside. But among institutions with less than $100 million of assets, the attrition rate skyrockets to 30-percent, with the industry losing 1,083 small banks and credit unions.
It should also be noted that 84-percent of the 373 institutions closed by the FDIC since 2006 have been institutions with less than $1 billion of assets, and 88-percent of the 1,426 mergers within the industry since 2006 have been with these same institutions. Rather than repopulate as with any endangered species, the FDIC has granted only a handful of new bank charters in the last few years.

While the statistics are most definitely accurate, I don't think they point to anything new in terms of regulatory attitudes towards community banks.  There were over 15,000 banks, most of them small, just over a decade ago.  The shrinking number of charters and concentration of assets is nothing new, and was not caused by the most recent financial crisis.  Instead, this is just a continuation of an existing trend.

With the role we play at our client banks, we are involved with safety and soundness exams with all of the primary financial regulators and many of the state regulators.  Rather than a widespread change in treatment of community banks, we see much wider range of interactions from regulators.  In short, solid and well run banks continue to have great relationships with their regulators.  They have credibility, and the field examiners are willing to have a give and take conversation with them.  Those that are weaker, or do not have a long track record, have a much steeper hill to climb.  They do not get the benefit of the doubt, but instead must prove beyond a reasonable doubt that they are properly identifying and managing risk.

The second half of the article, however, raises some valid issues that we have mentioned here several times:

Although the following statement may not be popular, smaller institutions need to get back to what they do best: making loans to consumers and small businesses. As a group, smaller institutions have higher leverage, Tier 1 risk-based capital, and total risk-based capital ratios than their larger competitors. Further, their net charge-offs to total loans and leases ratio is significantly lower than their larger competitors. And given that their net loans and leases to deposit ratios currently reside at a low level (especially those firms with less than $100 million of assets), they are primed for ramping up their lending activities. It is somewhat understandable why institutions have been hesitant to make loans given past credit problems and heightened regulatory scrutiny. However, the industry’s new crisis dictates that they do just that – lend.
As you readily know, financial institutions have only two ways to generate revenue: net interest income and non-interest income. Net interest income (interest income minus interest expense – the ratio expressed as the net interest margin {NIM}) is generated from assets held. Given that smaller institutions today are have fewer loans on the books then in the past, they are forced to rely more heavily on the investments they hold to generate interest income. However, the yields from those investments are relatively low in this Fed suppressed interest rate environment. Such an interest rate environment has been a great boon to institutions in terms of lower funding costs (a move to core deposits and away from time deposits), which has sustained so-called healthy net interest margins. The question becomes: How long will such a yield curve relationship last? As a result, the greater opportunity in the near term is to generate net interest income from loan production rather than investing.
With respect to non-interest income, it is more steer than a bull, neutered by recent laws and regulations with respect to credit card, debit card and overdraft fees – and who knows what may be down the road with Dodd-Frank’s new Consumer Financial Protection Bureau. The bottom line is the industry’s non-interest income stream has been and will remain limited, especially for smaller organizations.




Correspondingly, smaller firms, which lack the diversification of their larger competitors, must continue to explore and capitalize on the non-interest revenue streams that they are presented, which may mean re-pricing products/services and leveraging opportunities from non-traditional product sales.

So, we need more loans and more non-interest income.  We already knew that - the real question is, where does that stuff come from?  The article has two excellent pieces of advice in this regard.  First, you must differentiate.  The few banks out there growing loans tend to be niche lenders.  They have found a small slice of the market, and they are trying to own that one piece.  The days of a small bank trying to be all things to all people may be numbered, as that is a game we are likely to lose to the big guys.  The second is to get better at cross sales.  It is much easier to sell to someone that is already doing business with us than it is to drag in new business off the street.  We all need to do a better job of using the mountains of data we have on our customers to get to a larger share of their business.If we can effectively do those two things, then we stand a fighting chance of being one of those that survives and prospers in the coming years.