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.”
To 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.
On the regulatory front, post-Enron, banks have been bowled over by a wave of costly regulation, starting with the Sarbanes-Oxley Act, and continuing with the Bank Secrecy Act and Dodd-Frank. Initiatives from new governmental bodies such as the Consumer Financial Protection Bureau are also costing banks, in dollars and customers. The CFPB, for example, is in effect trying to regulate non-regulated financial services firms — like check-cashing and debt-collection businesses — through their lenders, adding to bank compliance burdens and causing them to sever relationships in those industries.
The Federal Reserve and the FDIC have in effect also shut off the creation of new banks. As noted in an early December letter from the Independent Community Bankers of America and The American Association of Bank Directors, the FDIC’s policy on de novo banks, adopted in 2009, makes “forming new banks prohibitive.” The lobbying groups cite the FDIC requiring “applicants to raise capital prior to opening that would be sufficient to maintain [the bank’s] leverage ratio at a minimum of 8 percent for the full 7 years [of its prospective business plan].”
For small businesses and other companies that bank with small, local financial institutions, this is a problem. Community banks often have branches in communities where big banks won’t venture. And, when these banks are acquired, the buyer often closes any money-losing locations, usually the branches in less economically desirable cities and towns.
The loss goes beyond bank branches. “Credit is the lifeblood of businesses,” Barragan says, and “the fewer institutions, the less access to capital there is.”
Regulators and Congress have helped small, private companies in other ways. The prime example is the JOBS Act’s easing of Securities and Exchange Commission reporting requirements and equity-investor solicitation. Meanwhile, high-level public debate about addressing the disappearance of small banks and how to support the continued viability of them is nonexistent.
“There’s a lot of discussion about too-big-to-fail, a lot of discussion about Basel, a lot of discussion about capital levels,” says Barragan, but not about small banks. “To the extent community banks are an important part of a diverse financial-services industry, particularly in underserved communities, what can be done to ensure they stick around?” he asks.