The Story of the Small Banks

The Washington Monthly has a good story looking at the successes of community banks, which are in pretty good shape unlike their “too big to fail” cousins staggering around the marketplace.

Last week, I pointed to a good piece by Daniel Gross in Newsweek that hits on some of similar topics. The Washington Monthly piece broadens into an argument for smaller-scale banking.

This is an amazing piece of information:

According to FDIC data, the failure rate among big banks (those with assets of $1 billion or more) is seven times greater than among small banks. Moreover, banks with less than $1 billion in assets—what are typically called community banks—are outperforming larger banks on most key measures, such as return on assets, charge-offs for bad loans, and net profit margin.

One reason community banks are doing so well right now is simply that they never became too clever for their own good. When other lenders, including underregulated giants like Ameriquest and Countrywide, started peddling ugly subprime mortgages, community banks stayed away. Banking regulations prevented them from taking on the kind of debt ratios assumed by their competitors, and ties to their customers and community ensured that predatory loans were out of the question.

And these banks are still lending, helping to prop up the economy the best they can.

Here’s some solid background info:

For decades now, most experts have argued that in finance, bigger is better. With their economies of scale, larger institutions are more efficient, goes the reasoning. They can match up lenders and borrowers all about the globe, tapping into places where money is piling up (like China or the United Arab Emirates) and directing those funds to borrowers in places where money is scarce (like Stockton, California, or East Cleveland, Ohio).

Such reasoning has held sway for a generation. The Monetary Control Act of 1980 made it easier for banks to merge, while also embracing a world in which middle-class Americans would put more and more of their savings into mutual funds and money market accounts. Another major change occurred in 1994, when large bank holding companies secured the freedom to set up branch networks outside their home states. Perhaps the biggest shift came in 1999, when (at the urging of Federal Reserve Chairman Alan Greenspan) Congress and the Clinton administration repealed the Depression-era Glass-Steagall Act, which had placed barriers between different kinds of financial institutions. After this repeal, commercial banks, investment houses, and insurance companies began to merge into complex, hybrid institutions that put ever-greater distance between borrowers and lenders.

With the shift in rules, transactional banking started to replace relationship banking. Big institutions bought up many community banks and set up new branches and ATM networks across state lines. Consumers responded favorably to the convenience of having access to everything in one place—brokerage accounts as well as traditional savings vehicles—and to being able to bank wherever they traveled.

Many small financial institutions tried desperately to compete by getting bigger themselves, and more than a few succeeded. Meanwhile, those that stayed small faced increasing challenges. Enormous, largely unregulated institutions like Countrywide and Ameriquest—“non-bank” banks—were competing very effectively for customers.

What the magazine (rightly) predicts next just can’t be allowed to happen:

Perversely, even as Washington prepares to distribute rescue dollars, it is once again the big banks that stand to come out ahead. When the latest crisis shakes out, the United States may well be left with just three or four titanic entities that will not only be “too big to fail” but also excessively powerful, even if heavily regulated. Already, just three institutions, Citigroup, Bank of America, and J. P. Morgan, hold more than 30 percent of the nation’s deposits and 40 percent of bank loans to corporations.

Half of all Americans do business with Bank of America.

There’s a serious conversation that needs to take place about the consolidation in our economy—especially in finance. If something is too big to fail, it should be disassembled to the point where its collapse would no longer endanger the rest of us.

The Washington Monthly’s piece is a good place to start.

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at Follow him on Twitter at @ryanchittum.