Small Banks, Regulation and National Small Business Week

By at 2 May, 2016, 9:26 pm

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by Raymond J. Keating-

National Small Business Week shouldn’t just be about the celebration of small businesses, but also about recognizing the challenges that entrepreneurs face and what can be done to remove unnecessary obstacles. Perhaps the biggest challenge for entrepreneurs seeking to start up and grow small businesses is access to financial capital. Unfortunately, the tough job of getting a small business loan, for example, seems to have gotten even tougher in recent times.

As noted in a recent SBE Council analysis, the value and number of small business loans outstanding have failed to recover to the levels reached prior to the late 2008 credit meltdown, and the small business loan share of total business loans also has declined dramatically.

Assorted and troubling reasons exist for this trend, including the continuing poor economy and a decline in entrepreneurial activity. In addition, challenges among small community banks stands out as another reason given the important role that community banks have played in lending to small businesses. The sources of community banking woes tie back to the state of the economy, but also to government regulation, which, by the way, always falls heaviest on the backs of small businesses, including small banks.

Consider key points from two recent reports on the state of community banks.

Community Banks Survived the Great Recession But are Having More Difficulty Under Dodd-Frank: A study published in February 2015 by the Harvard Kennedy School’s Mossavar-Rahmani Center for Business and Government, titled The State and Fate of Community Banking and authored by Marshall Lux and Robert Greene, looked at the role of community banking in the marketplace, as well as the impact of Dodd-Frank financial regulation law on these small banks.

The authors note that “community banks provide 51 percent of small business loans,” and quote William Grant, then chairman of the Community Bankers Council of the American Bankers Association, pointing out, “The cost of regulatory compliance as a share of operating expenses is two-and-a-half times greater for small banks than for large banks.”

As for the Dodd-Frank impact, the authors note, “Community banks (defined as banks with less than $10 billion in assets) withstood the financial crisis of 2008-09 with sizeable but not major losses in market share – shedding 6 percent of their share of U.S. banking assets between the second quarter of 2006 and mid-2010… But since the second quarter of 2010, around the time of the Dodd- Frank Wall Street Reform and Consumer Protection Act’s passage, we found community banks’ share of assets has shrunk drastically – over 12 percent.” They go on to observe: “Interestingly, community banks’ vitality has been challenged more in the years after Dodd-Frank than in the years during the crisis.”

And at another point, they state: “[C]ommunity bank consolidation trends have almost doubled since the passage of Dodd-Frank, relative to the Q2 2006 and Q2 2010 time frame, which includes the crisis period.” The authors added: “As the GAO reports, regulators, industry participants, and Fed studies all find that consolidation is likely driven by regulatory economies of scale – larger banks are better suited to handle heightened regulatory burdens than are smaller banks, causing the average costs of community banks to be higher.”

America is Losing Community Banks: As noted in a March 2015 report from the Federal Reserve Bank of Richmond, the sizeable decline in the number of community banks from 2007 to 2013 – shrinking by 41 percent – was not only about community bank failures, but about “an unprecedented collapse in new bank entry.”

It is noted: “This collapse in new bank entry has no precedent during the past 50 years, and it could have significant economic repercussions. In particular, the decline in new bank entry disproportionately decreases the number of community banks because most new banks start small. Since small banks have a comparative advantage in lending to small businesses, their declining number could affect the allocation of credit to different sectors in the economy.”

What’s the problem? Potential issues include the state of the economy and Federal Reserve policymaking: “An important factor in bank profitability is the net interest margin, or the spread between deposit rates and lending rates. The Fed’s policy of keeping the federal funds rate near zero since 2008 has pushed lending rates down, which has kept the net interest margin relatively small. Adams and Gramlich [of the Federal Reserve Board of Governors] estimate that this low interest rate environment coupled with weak demand for banking services accounts for as much as 80 percent of the decline in bank entry in recent years. However, a literal interpretation of their model would predict that even if the net interest margin and economic conditions recovered to 2006 levels, there still would be almost no new bank entry, suggesting that other factors are also important for explaining the recent decline.”

Other factors? Consider regulation. The authors write: “Banking scholars also have found that new entries are more likely when there are fewer regulatory restrictions. After the financial crisis, the number of new banking regulations increased with the passage of legislation such as the Dodd-Frank Act. Such regulations may be particularly burdensome for small banks that are just getting started.”

The Richmond Fed report concludes: “If de novos [i.e., newly formed banks] are absent due to the low interest rate environment and weak economic recovery, then entry should increase as the economy improves and the Fed raises interest rates. If regulatory costs are the driving force behind low entry rates, then future entry will depend on how those costs change over time.”

So, in the end, much of this ties back to misguided and costly public policy decisions. Dodd-Frank was more about political posturing against big banks, rather than dealing with the actual causes of the 2008-09 credit and economic mess, with the resulting regulatory costs hitting small banks hard. The Fed’s loose money also has created an obstacle to new bank formations. And finally, the imposition of higher taxes, increased regulation across vast sectors of our economy, and more government spending and intervention in the marketplace have raised costs, increased uncertainty, reduced or restrained entrepreneurship and business investment, and thereby lengthened the recession and led to this badly under-performing recovery/expansion period. Fix these policies, and the results will be good news for the economy, small banks, and small business.


Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.


Keating’s latest book published by SBE Council is titled Unleashing Small Business Through IP: The Role of Intellectual Property in Driving Entrepreneurship, Innovation and Investment and it is available free on SBE Council’s website here.


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