Three cheers for small banks

December 5, 2013
Matt Yglesias wrote a post about what he calls “America's Microbank Problem”: this country has far too many banks, he says, and they’re far too small.

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Earlier this week, Matt Yglesias wrote a post about what he calls “America’s Microbank Problem”: this country has far too many banks, he says, and they’re far too small. A rebuttal soon came from Rob Blackwell of American Banker, who called Yglesias “dead wrong”. This is an argument which clearly needs to be adjudicated! And in this case, I’m afraid, Blackwell wins.

It’s undeniably true that for various reasons, most of them regulatory, America has way more banks than any other country. Take away that history of regulations, and we’d have the “dozens” of banks Yglesias wants, rather than the thousands we actually have. But, would that be a good thing or a bad thing?

Yglesias says it would be a good thing, on the grounds that America’s existing “microbanks” are poorly managed; can’t be regulated; and can’t compete with the big banks. But Blackwell is absolutely right that none of these arguments really stands up to scrutiny.

Taking them in turn, Yglesias starts — without citing any evidence — by saying that smaller banks are poorly managed:

You know how the best and brightest of Wall Street royally screw up sometimes? This doesn’t get better when you drill down to the less-bright and not-as-good guys. It gets worse. And since small banks finance themselves almost entirely with loans from FDIC-ensured depositors, nobody is watching the store.

Actually, you do get less in the way of royal screw-ups as banks get smaller. Small banks are lenders, at heart: they take depositors’ money, and lend it out to their customers. If the customers prove creditworthy, then the bank makes money. Big banks, by contrast, are much more complex institutions, larded up with derivatives and Central Investment Offices and leveraged super-senior tranches of synthetic collateralized debt obligations, and so on and so forth. What’s more, all of those things can generate multi-million-dollar bonuses almost overnight for the wizards dreaming them up: no one waits until maturity. It’s that kind of opacity and complexity which produces the real disasters, not the simple business of lending money to borrowers.

As for the idea that FDIC insurance makes small banks riskier — well, that’s just bizarre. The FDIC crawls all over small banks, precisely because it has so much at risk. And because small banks have simple operations which are easy to understand, the FDIC can and does step in early when they start getting into trouble. Effectively, small banks have the better of two management teams: the in-house one, or the FDIC. And the FDIC knows what it’s doing.

Ygelsias’s second argument is equally weird: that small banks can’t be regulated, since they get carve-outs from lots of bank regulation. Again, this misses the big picture, which is that they are regulated, and regulated well, by the FDIC. What’s more, if the FDIC ever has any difficulty regulating these banks, all it needs to do is raise its dues to make up for the extra risk that it’s facing. Essentially, the US banking system regulates itself: the dues from profitable banks go towards rescuing troubled banks. The rest of us never need to worry. Except, of course, when the bank is so big that the FDIC can’t afford to let it go bust. It’s the too-big-to-fail banks which are the real problem, not the little ones.

What’s more, the carve-outs, such as they are, tend to make perfect sense, for banks which as a rule aren’t even allowed to engage in the relevant activities in the first place. (When I was on the board of a small credit union, for instance, we briefly talked about using interest-rate swaps to hedge our interest-rate exposure, before finding out that our regulator would never allow a credit union of our size to do such a thing.)

Besides, as Blackwell notes, small banks in fact are governed by nearly all the regulations which apply to big banks — including Basel III.

Finally, Yglesias says that small banks can’t just compete with big banks: “Having a large share of America’s banking sector tied up in tiny firms only makes it easier for a handful of big boys to monopolize big-time finance.” Well, yes — the small banks don’t do big-time finance. That, as they say, is a feature, not a bug. The fact is that the second-tier banks that Yglesias has his eyes on — banks like Fifth Third or PNC — would be insane to try to compete with Goldman Sachs in the big-time finance leagues. The international capital markets have seen dozens of second-tier banks attempt that move; they all end up losing billions of dollars and retreating with their tales between their legs. There big-time finance league is actually highly competitive: it includes not only US banks like Goldman and Morgan Stanley and JP Morgan and Citigroup and Bank of America, but also international banks like Deutsche and UBS and Barclays and Credit Suisse. We don’t need more banks in that league: the one thing they all have in common, after all, is that they’re too big to fail. That’s the table stakes.

Blackwell also notes that smaller banks are actually more profitable than the behemoths: if you have assets of between $1 billion and $10 billion, your return on equity is 9.9%, on average. That’s better than the TBTF contingent: there might be economies of scale at the low end, but they completely disappear by the time you get to $100 billion, even as the biggest banks have balance sheets measured in the trillions.

And taking a step back from the original Yglesias blog post, in general it’s always a good thing for banks to be small rather than big. If you’re a small bank, you know your local economy really well. The biggest difference, for me, between talking to a small-town banker and a big international banker is that big international bankers tend to know a lot about banking. Small-town bankers, on the other hand, often know surprisingly little about banking: they don’t need to. Instead, they know about agriculture, or manufacturing, or whatever the local industry might be.

The main role of banks in an economy is to allocate capital to places where it can be most productively used. In international finance, that role is played by the capital markets — which is one reason why big banks aren’t as necessary as small banks. But at the local level, what we really need is bankers who know their neighborhood and can help it grow by funding the best businesses. And small banks are better at that than big banks, where underwriting decisions tend to be automated, with local branch managers having very little discretion.

Smaller banks can pose a systemic risk, as we saw in the S&L crisis. They still need to be assiduously regulated. But give me small banks over big banks, any day. I feel that one of the hidden strengths of America is precisely that it has such a richly diversified banking system. And as web-based banking platforms start becoming available at reasonable cost to banks of all sizes, I suspect that community banks are only going to increase their market share going forwards. Good for them.


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