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For Small Banks, Life Fades Away

Over the last 30 years, the number of U.S. banks has been cut in half. Regulators don't seem interested in preventing further contraction.

Businesses that bank at small financial institutions have reason to worry about their diminutive counterparties. Small banks are more vulnerable than ever — not to a financial crisis, but to getting crushed by competitors and low interest rates or being consumed by acquisitive banking giants.

According to the latest count by the Federal Deposit Insurance Corporation, there were 6,891 financial institutions in the third quarter, the first time that number was below 7,000 since the Depression. The peak year was 1984, when the FDIC counted 14,483 banks. The population of small banks has gone through numerous culls, the most recent being the period since 2008. The current numbers would be even lower, in fact, if not for the hundreds of banks that received capital injections under the Troubled Asset Relief Program in that period.

Next year and beyond, the outlook is grim. “Long term, it will be difficult for banks under $500 million [in assets] to be viable, standalone institutions,” says Roberto Barragan, CEO and president of Aquaria Funds, an independent small-business lender. “They have a bullseye on their backs.”

Analysis_Bug3To a large extent, a decline in population of community banks and other small institutions was due. As Barragan, (a founding board member at California United Bank) describes it, the mid-2000s saw an explosion in bank startups. Barragan launched a credit union in 2005 with $2 million in deposits and $500,000 in capital.

By 2006, he says, “I was being invited to presentations left and right by former bankers trying to start their own bank and raise the $15 million to $25 million to launch it. Their presentations were what you see in these multilevel marketing programs: ‘Invest in the bank and you will have 10 times book value in seven years, and you will sell to some regional or national bank and make a lot of money.’ It was amazing to me how you could treat a regulated industry like it was some type of investment scheme. It kind of got crazy there for awhile.”

The pendulum has swung about as far from the craziness of the mid-2000s as it can; U.S. regulators have approved one de novo (startup) bank in three years.

It would be “foolhardy” for anyone to start a bank now, says Barragan. Economically, ultra-low interest rates and a competitive lending environment mean a de novo wouldn’t be able to earn much profit on investments or loans, he says, even with deposits bulging across the banking system.

Smaller banks, especially those with less than $100 million in assets, on average, have lower returns on equity, worse efficiency ratios (expenses as a percentage of revenue) and, at least in the third quarter of 2013, a higher percentage of non-current business loans. In real-estate lending, a traditional area of strength for small banks, many can no longer compete. “A national bank will do a loan at prime or one point above prime; a community bank can’t do that,” Barragan says.

3 thoughts on “For Small Banks, Life Fades Away

  1. Having worked for both large and small banks, the loss of the small banks will have a negative impact on the economy and small businesses. Due in large part to the limitations on maximum size of loans, small banks are limited to dealing with small businesses. It takes approximately the same amount of time and expense to make a large loan as it does to make a small loan. The large banks place their marketing efforts at the larger businesses where they will receive a higher impact for the bank relative to increased revenue and assets.

    In addition, the larger banks have moved credit scoring, initially used for consumer lending, to the small business arena. The lenders have little if any authority to affect the outcome of the program. On the other hand, the small banks look at each loan request more closely and can more easily allow for mitigating circumstances.

    The bottom line is that the decline in small banks will have a negative impact on the ability of the small businesses to obtain loans.

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