Three cheers for small banks

By Felix Salmon
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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I wonder how hard it would be to construct something like a franchise-able bank? If the essence of the good small-town banker is that he knows who can be trusted with borrowed money, if there’s a way to free that guy up from needing to handle the infrastructure of handling deposits and withdrawals, sending out statements, issuing debit cards and processing their transactions, running a website with features like online bill pay, and all the rest… then providing all of those things seems like a viable business model.

There’s no particular reason that the experience of banking with New Resource Bank needs to be particularly distinct from Lower East Side People’s Credit Union. The big differentiating factor is just their focuses in lending, right? NRB finances clean power installations for homes and businesses, helps guide business clients to energy efficiency upgrades, and that kind of thing. LES People’s presumably has some other specialty. But a single business could probably, with lower overhead, provide basics like a web infrastructure, debit cards, etc, to both of them, and a thousand more local specialty banks.

Posted by Auros | Report as abusive

“I suspect that community banks are only going to increase their market share going forwards.”

Ach! You had me until the last line. Yglesias had a rare misstep here. The smaller banks I’ve worked for have been very tightly managed. Surprisingly ignorant of the basic mechanisms of, well, banking – but as you say, a feature, not a bug.

But from an insiders view, the past few years have been typified by relentless, constant consolidation. That’s part and parcel of modern banking, but the crisis has hardly helped.

To me, while online banking platforms are a wonderful benefit for the consumer, they’ve been terrible for community banks. It adds another layer of per-user cost when the technology is outsourced to a technology provider.

That plays right into the hands of the big banks, who have the necessary capability to develop and maintain their own propertiary systems. It allows very agile and well funded banks (think USAA) to innovate relentlessly, while small-cap regionals are dependent on third-parties. And in my limited experience, most third party online banking providers are clunky, beholden to far too any clients, and unable to deliver on anything other than mostly dated and re-iterative ideas.

And even those banks that introduce more modern online options struggle. I’ve worked on three OB implementations and none have driven significant market share. Locally, it’s just playing keep up with larger banks. And although having a robust online infrastructure means you could theoretically expand your geographic footprint, that plays against the strength of community institutions which, as you say, are mostly local.

I prefer small and regional banks, but on this one point, Yglesias is right. I don’t see anything other than further growth for the big boys in bankings future.

Posted by strawman | Report as abusive

Not only do I prefer smaller banks and credit unions, as a matter of conscience I decided a few years ago to simply stop doing business with any of the big 6. OK, OK, I do have a Citi credit card but I pay it off religiously every month. Aside from that it’s strictly the smaller guys and credit unions. Why would I want to support big banks, for me they are as destructive as big tobacco.

Posted by Missinginaction | Report as abusive

I worked 25 years in lending in a small community bank until retiring. The problem facing small banks is that they are left having to make lemonade out of the market segments not desired by large institutions (banks and GSEs) and credit unions. Thus their variety of products is being reduced and they get pushed into riskier loan types or geographic areas shunned by the big boys. So you see banks failing due to overexposure to higher risk loans such as housing/development loans.
In particular something needs to be done about credit unions’ tax exemption which they use to systematically undercut banks in whatever markets they select such as automobile loans.

Posted by flowergardener | Report as abusive

“And the FDIC knows what it’s doing”

I’m assuming that was a joke

Posted by seanbmcnulty | Report as abusive

1) Small banks did not cause the 2008 crash: large ones did.
2) Small banks have much better service.
3) We should intervene all large banks, at least the top 50, and split them up.
4) Small banks were not bailed-out with hundreds of billions of taxpayer dollars due to incompetence and fraud.
5) Large, international banks present a clear and present danger to the world because they cannot be dismantled easily.
6) Matt Yglesias is an apologist for the Obama administration, especially for Tim Geither, perhaps the most incompetent Treasury Secretary of all time. Read Neil Barofsky’s book “Bailout: How Washington Abandoned Main Street While Rescuing Wall Street” and Bill Black’s scathing commentary on another Yglesias fairy tale (URL below). ill-black-yglesias-pours-the-geithner-ho lder-breuer-ghb-banksters-immunity-doctr ine-in-our-drinks.html

Posted by baroque-quest | Report as abusive

Small banks did not cause the 2008 crash. Thought they participated heavily in the mortgage bubble, most of them sold the mortgages promptly to Fannie Mae or to investment banks.

The previous financial debacle, S&L – yes, small banks caused it.

Posted by yurakm | Report as abusive

It’s amazing how banking has evolved today. Financial services such as interest-free credit finance solutions are now being marketed online. This includes personal loans and business loans as well.

Posted by Funda-au | Report as abusive