Community Banks

Jobs are the number one economic and political issue of today despite the better than expected April employment data.  Try as they might, no amount of fiscal stimulus and excess reserve creation appears to be working.  And most politicians are baffled as to why.

The monetary and fiscal medicine administered may have worked within the institutional structures of the past, but those structures have radically changed.  Part of the jobs issue is right in front of our noses.  Simply put, the rapid changes in U.S. financial institutions over the past 25 years have been detrimental to job creation in the U.S. because capital is no longer readily available to the entrepreneurial small business sector, widely acknowledged as America’s engine of job creation.

The Changing Financial Landscape

From 1983 to 1989, the number of new community bank charters averaged 297/year.  In the 90s and throughout much of the last decade, the average was more than 130/year.  But, since the financial meltdown, new charters have all but disappeared; there were 29 in ’09, and only 1 last year.  Meanwhile, community banks have been disappearing over the past 25 years through consolidation, driven partly by overregulation, and, lately, by outright failures.  In 1984, there were 14,507 commercial banks; nearly all were community banks.  At the end of ’09, that number had fallen to 6,840.

At the same time, the big have become gigantic.  The table below shows the percentage of U.S. deposits of the largest banks in 1994, and then for 2009.

Percentage of Total Bank Deposits

The 1994 Reigle-Neal law allowed banks to cross state lines to branch or purchase other institutions without restrictions, but put a 10% cap on deposits for any single institution.  There were loopholes, one of which allowed banks to exceed the 10% limit if it were caused by the assumption of a failing institution.  So, the last few years have seen a feeding frenzy for the megabanks.  For example, Bank of America absorbed Merrill Lynch soon after they purchased Countrywide, JPMorganChase acquired Washington Mutual, and Wells Fargo took on Wachovia.  Clearly, what was considered “large” in the 90s is now dwarfed by these whales.

In 1999, with the repeal of the Glass-Steagall Act, the megabanks were able to cross the investment banking line, which had been forbidden to them since the 1930s.  And, from that time forward, their capital ratios fell as the natural inclination of an investment banker is to use leverage.

Shadow Banks

These megabanks, even when they were merely “large”, were never community and small business lenders.  Instead, in the 80s and 90s, and up to the financial meltdown of ’08, these institutions set up lines of credit lending to the “shadow” banking system.  By doing so, they were able to avoid the overhead and expense of managing large portfolios of small loans.  The “shadow” banks were largely unregulated and they became the lenders to consumers and small businesses, and consisted mainly of mortgage companies and consumer lenders.  Many of these “shadow” banks got crushed in the financial meltdown and no longer exist.

TARP

Besides the “shadow” banks, community banks have traditionally been community and small business lenders.  And, in contrast to the megabanks, community banks have historically had higher capital ratios.  But, like the megabanks, community institutions were hard hit by the financial meltdown.  In ’08 and ’09, the TARP program was rolled out.  It was supposed to save the financial system, but what it saved was the Wall Street megabanks, as the lion’s share of TARP funds went to America’s 19 largest institutions.  In an academic paper entitled TARP Investments: Financials and Politics (June 27, 2010), authors Duchin and Sosyura (University of Michigan) found that of the 714 TARP investments made, larger banks were favored, and that political activism was a large contributing factor in determining if a small bank would receive TARP funding.

Access to Capital

By the end of the financial crisis, the megabanks were able to access the capital markets to pay back their TARP loans and to beef up their capital bases to be able to weather the coming onslaught of souring loans.  They were able to access the capital markets because the market participants knew that these banks were “Too Big To Fail”.

The Fed has extended huge volumes of liquidity and created unprecedented levels of excess reserves through their QE1 and QE2 programs.  Most of this excess had ended up on the balance sheets of the megabanks.  But until this past March, commercial and industrial loans continued to shrink.  From their peak in October ’08 to their trough in October ’10, such loans contracted by 24.75%.  From last October through March, they have turned up slightly, and I note that the unemployment rate began responding in December.   Rather than lend, the megabanks used their reserves to purchase new debt issued by the Treasury.  For the three years ending in February, government securities on bank balance sheets have risen 50% or by $545 billion.

Unlike the megabanks, community banks have no such access to capital.  Like the megabanks, community banks suffered loan quality issues, and many of these institutions now have “impaired” capital.  That means that their capital levels are below regulatory standards.  Many community institutions are under regulatory orders, and, in almost every case, those orders require additional capital.  Until they raise such capital, their capital ratios do not permit them to lend new funds.  Furthermore, the regulators are generally heavy handed, and, the capital that may be available is hesitant to enter for fear (borne out by many anecdotal stories) that the regulators will not quickly release the institution from its regulatory shackles. (Ask any community bank CEO with a regulatory order “who runs the bank”: it’s not management; it’s not the board, the answer is “the regulators”. )

Conclusion:  No Lending – No Jobs

In the end, the capital markets are largely unavailable to community banks, and the regulatory process has displayed a complete lack of sensitivity to which institutions actually lend to small businesses, America’s job creators.  What is said in Washington and what is practiced in the field are two completely different things.  As a result, the Wall Street megabanks get bigger and fatter, and have used the reserves created by the Fed, not for new loans, but to purchase newly created government debt.  The community banks, the only remaining lenders to America’s small businesses, without access to capital, and under the thumbs of their regulators, continue to disappear, and those that have survived are generally not able to lend or simply are too small to make a material difference.  The end result: Washington is happy (someone is buying their debt); Wall Street is happy (free money and wide spreads); but America still has no jobs.

Robert Barone, Ph.D.

May 5, 2011