Who murdered the community bank?

It wasn't Dodd-Frank...

Americans got some good news about the financial industry in the last week. Unfortunately, it quickly turned into a murder mystery.

The good news is that the U.S. financial system is considerably sturdier than it used to be. The Federal Reserve released the results from two different forms of stress tests it ran on the country's biggest banks, and found that all 33 banks had big enough cushions of shareholder money to survive a serious recession. The second batch of tests looked at the banks' internal procedures, risk management, and other questions of institutional design. The results for those tests were almost as good: Morgan Stanley was asked to resubmit a plan, and two U.S. subsidiaries of Deutsche Bank and Santander got negative results as well. But that was it.

In fact, capital cushions have doubled in size since the crisis, and a government report back in 2014 concluded the likelihood of future bailouts has shrunk significantly. This is largely thanks to the 2010 Dodd-Frank reform bill, which slapped many new regulations on the financial industry — the biggest banks especially — and jacked up their required capital cushions. (Though arguably it needs to go farther.)

Sounds great, right? What's the downside? It's that the small members of the financial industry have been getting wiped out.

Banks with under $10 billion in assets accounted for 40 percent of all bank assets in 1994, then fell to 18 percent in 2014. At the same time, assets of the top five banks grew from 20 percent to 46 percent. The number of banks with under $100 million fell 85 percent from 1985 to 2013. In fact, credit unions and banks with only one physical location have been on a continuous slide into obscurity since the mid-1980s.

A lot of this has been due to bank mergers, especially in the 1990s, plus a long decline in the number of new banks created.

And a lot of Republicans and conservatives think Dodd-Frank is to blame. "Dodd-Frank has crippled community banks and increased the cost of lending for too many Americans," Marco Rubio tweeted in 2015. Rep. Jeb Hensarling (R-Texas), the chairman of the House Financial Services Committee, has been on a tear to dismantle Dodd-Frank for a few years now, citing this very point.

Even among less ideological analysts, the basic complaint is that while Dodd-Frank may have made the financial system safer, the new capital requirements and regulatory burdens it imposed have made life much harder for smaller banks. As a result, more are failing or being absorbed by larger institutions, and fewer are being created in the first place. So the financial system is becoming dominated even more by the biggest players.

Some liberal defenders of Dodd-Frank simply argue this is a good thing: Fewer and larger banks make the system more stable and easier for the government to oversee. But the counter-argument is that smaller community banks fulfill crucial needs: They do much more of the lending to homeowners and small business owners. And because they know the communities and neighborhoods in which they operate intimately, they are better at managing the risks of their loans than some distant mega-bank.

The question, though, is whether Dodd-Frank is really the killer that's been murdering off small banks. Could something else have done it?

An initial problem with the Dodd-Frank-as-murderer theory should be obvious: The reform was passed in 2010, but small banks have been dying for 30 years. The right-leaning Mercatus Center tried to fill in the blanks here, arguing that regulations were increasing well before Dodd-Frank. According to their 2013 report, various regulatory codes concerning banking increased by 17 percent or more from 1998 to 2013. It is, of course, possible that this played a role. But Mercatus' methodology was a bit weird: They just went through the code and identified how often certain "restrictive words and phrases" showed up. This seems like a sketchy metric of the regulatory burden.

A simpler explanation probably lies in the business model of banks themselves: They turn a profit by ensuring that the loans they make bring in more money than what they have to pay to savers. This is especially key for smaller banks, whose business models are less diversified than the big players. So higher interest rates give small banks more room to maximize that spread.

But since the 1980s, interest rates have been on a long slide and are now near historic lows. Nor is there any sign that they'll be rising in the near future. A 2014 study by the Federal Reserve found that three quarters of the decline in small banks since 1990 can be attributed to the environment of low interest rates.

You can also see this in the profit margins for big and small banks, which have actually been converging in the last few years. If regulation was the problem here, you ought to see the difference between those profit margins expanding as Dodd-Frank ran the smaller players into the ground.

Ultimately, banks are like any other private business: They provide a service for a profit. To survive, they need customers for that service. Chronically low interest rates are a sign of a sick economy, in which case there are just going to be fewer customers and less demand for startup business to build on. And like any other business, size helps banks weather that kind of environment.

Small community banks are dying, and that's bad for the economy and American society. But blaming regulation misses the fact that, when the economy is ill, it's always the little guys who die off first.


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