AEI on Dodd-Frank and Community Banks

AEI released an excellent paper this week by Tanya Marsh and Joseph Norman, “The Impact of Dodd-Frank on Community Banks,” detailing the damage the financial reform bill has inflicted on these important institutions. As the authors explain, the Consumer Financial Protection Bureau (currently the subject of a constitutional challenge I’ve written about) is imposing significant costs on relationship-based banking and threatening the survival of the banks that are vital to our “Main Street” economy.

The study was released on the heels of a Washington Post story by Robert Kaiser detailing how Barney Frank convinced the influential Independent Community Bankers of America — the community bankers’ lobby — to stay on the sidelines during the fight over Dodd-Frank’s passage. The ICBA’s cooperation was secured in exchange for a reduction in FDIC assessments for smaller banks, and a Faustian bargain that did nothing to free those same banks from the CFPB’s oppressive regulatory regime.

Needless to say, the bargain hasn’t worked out so well for community banks. The CFPB tends to encourage standardized financial products — products with pre-determined, not customizable terms, with eligibility that comes from numbers crunching rather than an evaluation of a customer’s complete circumstances. In particular, the CFPB’s excessive regulatory regime ensures this, by prohibiting certain products with customizable terms altogether. Compounding this problem is the CFPB’s ability to prohibit “abusive practices” — how’s that for broad, subjective authority? — which unpredictably lets the CFPB ban certain financial products from being issued by big and small banks alike.

The standardization resulting from Dodd-Frank comes at the expense of the relationship banking model, the preferred model of many community banks. According to James H. McKillop, III, in Congressional testimony for the Independent Community Bankers of America:

Community banks . . . serve rural, small town, and suburban customers and markets that are not comprehensively served by large banks. Our business is based on longstanding relationships in the communities in which we live. We make loans often passed over by the large banks because a community banker’s personal knowledge of the community and the borrower provides firsthand insight into the true credit quality of a loan, in stark contrast to the statistical models used by large banks located in other states and regions. These localized credit decisions, made one-by-one by thousands of community bankers, support small businesses, economic growth, and job creation.

The CFPB’s vast regulatory web also forces community banks to pour money into compliance and away from lending. In Florida, 96 percent of community banks and credit unions “expect to spend considerably more time and money on compliance with new federal regulations over the next three years,” while 64 percent expect to hire new compliance staff and reduce their lending. The State National Bank of Big Spring, Texas, a plaintiff in the Dodd-Frank lawsuit, suspended its entire residential-mortgage division for fear of CFPB liability. Twelve hundred rural US counties would have “severely limited banking access” without community bankers, who also serve other key sectors of our economy:

Community banks provide 48.1 percent of small business loans issued by US banks, 15.7 percent of residential mortgage lending, 43.8 percent of farmland lending, 42.8 percent of farm lending, and 34.7 percent of commercial real estate loans, and they held 20 percent of all retail deposits at US banks as of 2010.

Democrats sold the CFPB as a response to the last financial crisis, and consumers did need a watchdog for protection from predatory lending. However, Marsh and Norman persuasively explain that community banks had little or nothing to do with the major causes of the financial crisis, including subprime lending, securitization, and derivatives. Overall, “total residential mortgage defaults at community banks [made] up only 2 percent of all defaults between 2003 and 2010,” while “[c]ommunity banks participated in only 0.07 percent of residential mortgage securitization activities between 2003 and 2010.”

Nonetheless, the cost of complying with the new regulatory regime will probably drive many of those same community banks out of business, or at least lower the quality and quantity of the services they can offer the customers in their communities. Meanwhile, as I wrote back in February, large banks will continue to rely upon lawyers, lobbyists, and in-house regulatory-compliance divisions to bear their regulatory burden. Which means that one net result of Dodd-Frank will probably be to increase the market share of the megabanks that caused the financial crisis in the first place, at the expense of the kind of banks that were actually behaving responsibly.