Community Banks Too Small to Fail
Dan Clore
http://groups.yahoo.com/group/smygo
[I'm glad I keep my savings in a credit union.--DC]
http://tinyurl.com/5bmtpf
Too Small to Fail
While the behemoths of Wall Street
stumble and fall, humble local banks are
doing just fine, thank you. Their surprising
resilience holds a key lesson for
twenty-first-century global finance.
By Phillip Longman and T. A. Frank
When Paul Hudson, the chairman and CEO of Broadway Federal Bank in Los
Angeles, speaks of the current financial crisis, he sounds altogether
placid. "It’s going to be difficult, because everybody participated in
this low-cost-credit, high-value-asset scenario," he says. "But I’m not
overly stressed." It helps that his own bank is doing fine. Broadway
Federal, founded in 1946 to provide loans to the growing African
American community of Los Angeles, is a small institution with five
branches located in middle-class, largely black neighborhoods of the
city. It has eighty-four employees, assets of $390 million, and a loan
portfolio divided more or less equally among single-family homes,
apartment buildings, churches, commercial real estate, and small businesses.
Aesthetically, Broadway Federal’s branches are more evocative of 1972
than of 1946—copious concrete, cheap terrazzo, fluorescent lights,
clunky logo. But in 2008, an old-fashioned look—even one from the
’70s—can be an advantage, for it suggests old-fashioned banking. While
Broadway Federal may have been less adventurous or less profitable than
some of its competitors over the past few years, today it enjoys the
traditionalist’s compensation of being both sane and solvent. In fact,
according to data from the Federal Deposit Insurance Corporation,
Broadway enjoys a substantially higher return on equity and assets than
J. P. Morgan does. (It also has a lower proportion of nonperforming loans.)
Broadway Federal’s story isn’t exceptional. Easily overlooked amid the
crisis of big banks today, small-scale financial institutions are, for
the most part, holding steady—and sometimes even better than steady.
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. Broadway Federal,
for its part, got out of single-family mortgages when they stopped
making sense. "A borrower comes and asks, ‘Do you do interest-only,
no-down-payment, option ARMs?’ " recalls Hudson, with a chuckle. "No!"
The bank focused instead on expanding its reach to niche borrowers, such
as local churches.
Today, however, even as many financial institutions are refusing credit,
Broadway Federal quietly continues to extend it. One recent recipient
was a nonprofit called the Domestic Violence Center of Santa Clarita
Valley, which needed $40,000 as a bridge loan in the midst of state
budget holdups. Nicole Shellcroft, the executive director of the center,
says that no large bank had been willing to lend the money. Under the
terms worked out with Broadway Federal, though, the domestic violence
center was given a three-month loan for a fee of $900 in interest. "Our
board was really happy with the terms," says Shellcroft. "It was
actually better than a line of credit." Beyond offering special loans,
Broadway has been attracting customers by being accommodating and
personalized. "I can proudly take in my money daily, deposit it, and get
access to my money directly," notes Angela Dean, founder of DeanZign, a
local fashion company. Dean recently switched over from Washington
Mutual to Broadway Federal for her business checking. She’s not alone.
In 2007, before the crisis had properly struck, Broadway Federal
experienced $7 million in net deposit growth. This year, as of June 30,
says Hudson, net deposit growth was at $25 million.
Community banks come in different forms. Some are "country club" banks
for the wealthy. Others are "community development banks," such as
Chicago’s South Shore National Bank, formed as part of an idealistic
effort to serve the "unbanked" in blighted neighborhoods. And many, like
Broadway Federal, are small-scale banks, credit unions, and thrift
institutions, often with origins back in the Progressive era and
earlier, when working-class men and women began pooling their savings
together and making loans to one another in order to overcome the
discrimination they faced from established banks. What all of these
varieties have in common are a connection to a small geographical area
and a personalized approach to customers. Whereas large banks rely on
"transactional banking"—in which formulas and set calculations govern
lending decisions—community banks rely on "relationship banking," in
which all sorts of personalized considerations enter into the picture.
This allows people like Nicole Shellcroft to secure prudent loans that
might otherwise be out of reach. "That’s what a community bank does,"
says Hudson, who is the grandson of one of the bank’s founders. "It sits
down with you and works it out."
Today, with the world’s system of anonymous high finance in crisis,
small-scale community banks, thrifts, and credit unions—all regarded
until recently as vestigial players in a new world of global consumer
finance—are setting an important example. If federal policies were in
place to provide proper support to small-scale financial institutions,
Washington could do a lot to alleviate the country’s most serious
economic problems: its lack of savings, its runaway consumer debt, its
dwindling supplies of social capital, and its vulnerability to financial
contagion brought on by Wall Street excess. By encouraging thrift,
responsibility, and a sense of community, small-scale financial
institutions could play a leading role in helping us dig out of this
financial meltdown—and in helping to fend off the next one.
Big Banks, Big Bust
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. These behemoths raised their funds not from depositors, but
from global capital markets, and, since they did most of their business
over the Internet or through freelance mortgage brokers, they had
minimal overhead. Exempt from the legal requirements to invest in the
local communities that normal banks must honor, these institutions could
easily have been seen as predatory. Instead, many people applauded how
entities like Countrywide were "democratizing credit," long a goal of
liberal public policy.
At the same time, social attitudes subtly changed, thanks in no small
measure to shrewd advertising. Mortgage originators like LendingTree ran
TV commercials mocking the idea that a consumer would show personal
loyalty to any one bank or banker. "When banks compete, you win," is the
LendingTree slogan.
As transactional banking expanded, the market share of small-scale
financial institutions shrank dramatically. In 1985, there were 14,000
community banks with inflation-adjusted assets of less than $1 billion.
Today, their number is smaller by half. Many communities, especially
those in urban America, have lost most or all of their local banks. Not
only has this left people in many communities with no place to open a
savings account or take out a small loan (aside from payday lenders), it
has also dried up a critical source of lending to small businesses.
(Community banks make nearly three times as many small business loans on
a dollar-for-dollar basis as do large banks, according to the Federal
Reserve.)
Until the current crisis, many ascribed such outcomes simply to the
logic of the market. Looking back, however, we can see that global-scale
finance wasn’t really so efficient after all, except in the sense of
being very efficient at wasting the world’s capital. Throughout this
decade, the world, if not America, became awash with savings. Rising
energy prices created trillions of petrodollars, while America’s
continuing trade deficits left our trading partners with trillions more
in surplus funds. All that money had to be invested somewhere. That
somewhere turned out to be in complex and often nonsensical financial
concoctions—most of them based on empires of McMansions and tract houses
in remote, jobless suburbs. The easy money fueled more demand for
imports, thereby keeping the global financial system in balance—
until, that is, it imploded.
Today we can see that the world’s surplus of capital could have been
more profitably invested in just about anything else. (How much better
to have borrowed money to repair our infrastructure, retool our
industry, or promote sustainable energy!) When the going still seemed
good, though, big banks took on more and more debt to stay competitive.
By the end, Lehman Brothers was borrowing forty-five dollars for every
dollar of its own that it was lending. Like a shark, it had evolved into
a highly efficient predator that had to keep moving or perish.
Small financial institutions, by contrast, had neither the opportunity
nor the incentive to imitate the large ones. Cushioned by their
deposits, they could hunker down while the mortgage markets went crazy.
This also meant they could get by if credit markets froze—as they
eventually did. In community banks, both borrower and lender maintained
a serious stake in the long-term outcomes of their transactions. For
deposits, the banks kept relying on the same people to whom they made
loans. Because the banks tended to hold on to their loans instead of
selling them to distant investors, they took care to avoid granting
loans to customers who couldn’t repay them. Social pressure also helped
to stave off predatory lending. When savers, borrowers, and lenders all
live in the same community, lenders don’t write loans that amount to
financial crack. They know their business depends on their good
reputation. Similarly, borrowers, who prize the good opinion of their
neighbors, don’t easily walk away from their loans.
In small-scale banking, then, borrowers and lenders can effectively see
one another. They’re rich with what Federal Reserve Chairman Ben
Bernanke calls "informational capital," and this has a stabilizing
influence. As savings-and-loan chief George Bailey tells his panicked
depositors in the 1946 film It’s a Wonderful Life, their money is safe
because it’s being loaned out to trusted friends and neighbors: "Well,
your money’s in Joe’s house. That’s right next to yours. And in the
Kennedy house, and Mrs. Macklin’s house, and a hundred others. Why,
you’re lending them the money to build, and then they’re going to pay it
back to you as best they can."
Having an abundance of informational capital not only helps to prevent
bank runs, it also keeps default rates low (which is why, for example,
faith-based credit unions can afford to offer payday loans at
non-usurious rates). Lending based on character also becomes possible.
The bright young man or woman with a strong business plan doesn’t get
turned down just for missing some lending formula ratio concocted in a
faraway bank holding company headquarters by bureaucrats who know
nothing of local conditions or the character of local customers. As one
Federal Reserve report notes, "Locally focused community banks have a
clear advantage at assessing the creditworthiness, and monitoring the
ongoing condition, of small and medium-sized businesses. These loans are
customized to reflect the idiosyncrasies of these borrowers and cannot
be ‘put in a box’ for credit-scoring and securitization."
A healthy relationship between borrowers and lenders can have another
important effect: promoting greater savings. Without easy access to
global financial markets, small banks are heavily dependent on their
depositors for capital. This means they have a financial incentive to
inculcate thrift, as all banks once did before America began importing
so much foreign capital. Older readers will remember "Thrift Week," an
institution, sponsored by the banking industry and others, that started
each year on Benjamin Franklin’s birthday (until it petered out in the
1960s). They’ll also remember how major banks used to offer customers
promotional items like toasters for opening savings accounts and tried
to inculcate thrift in youngsters through school banking programs. (And,
indeed, some local banks in small communities still do this.) Before we
began importing most of our savings, all banks needed customers who
saved sufficiently and were not ruined by debt.
Naturally, being so closely tied to the fortunes of the community makes
small banks more vulnerable to local downturns than large banks. But
this isn’t all bad, since it gives local bankers an interest in bringing
their town’s business community and civic groups together to solve
common problems and find new ways to prosper. For community banks,
community involvement is central. In a Grant Thornton survey of
community bank chief executive officers conducted in 2001, almost all
reported participating in civic groups (94 percent) or their local
chamber of commerce (92 percent). More than half reported that their
banks supported local relief efforts and special help to low-income
segments of the community. Today, many parts of the country have lost
their civically engaged local bankers, and this absence is strongly felt.
None of this is to say that small-scale banking is virtuous in every
respect. In the past, if you couldn’t form a good relationship with your
community’s bankers—perhaps because you were from the wrong ethnic
group, or just unpopular with your neighbors—you were often out of luck.
Community banks have frequently been clannish in choosing their
customers. They have also been known to take in deposits from customers
in poorer neighborhoods while reserving their loans for customers in
richer neighborhoods.
But public policy can do (and already has done) a lot to ensure that
community banks are investing in their own communities. For three
decades before the current financial crisis, for example, the Community
Reinvestment Act nudged banks large and small into lending in areas that
were previously "redlined"—that is, avoided by banks. (Although
conservatives have recently been eager to tar the Community Reinvestment
Act as responsible for the current crisis, the contention is ludicrous.
Numerous studies have shown that the overwhelming number of bad subprime
loans were made by financial institutions not covered by the act.)
Moreover, even without federal regulation, small-scale banking has
always offered an opportunity for excluded groups to help themselves in
the face of discrimination. In 1913, for example, there were more than
200 so-called "immigrant banks"—including fifty-five for Italians,
twenty-two for Germans, sixteen for Poles, and six for Jews—in Chicago
alone. Many such immigrant banks survive today and have since shed their
exclusivity. Suburban Baltimore’s Madison Bohemian Savings Bank no
longer limits its loans to the Bohemian farmers of Hereford County—or
even to Bohemians.
Taming Goliath
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. Now, some of the
big banks receiving "rescue money" from the Treasury report that they
intend to use it to acquire smaller banks. Only if community banks are
given a fair chance in this environment will Americans have proper,
sober alternatives to being banked by Goliath. Otherwise, the distance
between lender and borrower will only grow, creating even more problems
in the future.
Under the Treasury’s rescue plan, some healthy small banks have the
chance to apply for infusions of publicly funded equity capital. But
this is a temporary, emergency measure. For the longer term, we need to
ensure that the small aren’t devoured by the large and that the system
as a whole remains balanced.
Community banks and credit unions don’t need a bailout, but they could
use support to deal with a few serious major challenges. First,
predatory lenders—the worst of the mortgage brokers, pawnshops, payday
lenders, and the like—must be shut down, so that space will be cleared
for traditional financial institutions dedicated to thrift and long-term
relationships. (When Washington, D.C., finally shut down payday lending,
local credit unions saw an upsurge in business.) Second, and more
urgent, small-scale financial institutions must have readier access to
capital. That means having enough funds on hand to make loans that
generate a modest but reasonable rate of return. Currently, community
banks are experiencing an upsurge in deposits from Americans burned by
losses elsewhere, but a robust community banking sector requires
long-term funding, and deposit levels, by nature, fluctuate as
individual customers move their money in and out of their accounts. The
best source of the funding community banks need to make long-term loans
is equity capital from investors. But most small banks are privately
held, and lately, convincing investors to buy bank stocks is difficult.
That’s where Washington could come in. A "Community Bank Trust Fund"
could be established to provide small-scale financial institutions that
met certain federal standards—in terms of size and of level of
investment in the local community—with equity capital. The trust fund
could purchase preferred stock in institutions that were looking for
capital to grow, just as Treasury’s rescue plan is now doing for mostly
large banks on a temporary, emergency basis. As with the Treasury plan,
these funds would be at risk, but could also earn a healthy return for
taxpayers if all goes well.
Instead of merely borrowing the money—as we are currently doing with the
Treasury’s rescue plan—we could do something more fiscally responsible:
tax transactional banking. Specifically, we could impose a fee on the
securitized loan transactions that are at the heart of the current
crisis—and use the money to invest in the Community Bank Trust Fund. In
other words, every time J. P. Morgan wants to bundle up a bunch of
mortgages, credit card debts, and student loans, slice and dice them
into impossibly complex derivatives, and sell the paper to unsuspecting
investors around the world, it should pay a tax on the transaction, with
the money going to support small-scale, relationship banking.
Certainly, no one wants special coddling or protection of small-scale
bankers, eroding their competitiveness and spirit of enterprise. And
there is, to be sure, a useful role to be played by properly regulated
global financial institutions. But friendly policies aimed specifically
at community banks would be a helpful counter to several decades of bias
toward large institutions. As Paul Hudson of Broadway Federal says, "The
point is, people should have a choice." They should also have a
financial system that is more resistant to contagion of the sort now
afflicting large banks.
Since the Progressive era and earlier, community banks, thrifts, and
credit unions have served customers in a manner that has promoted
community building and mutuality while also serving as a check against
monopoly finance. Before the recent meltdown of the global financial
system, singing the virtues of such small-scale banks might have seemed
nostalgic and romantic. After the painful bursting of three financial
bubbles in a decade, however, paying attention to those virtues is both
essential and hard-headed. It’s a vital first step as we attempt to
recover from years of financial abuse and excessive faith in all things
large.
Phillip Longman, a senior fellow at the New America Foundation, is
coauthor, with Ray Boshara, of the forthcoming book The Next Progressive
Era, from which this article is partially adapted.
T. A. Frank is an Irvine Fellow at the New America Foundation and an
editor at the Washington Monthly. Ellen Seidman, director of financial
services policy at New America, and formerly director of the Office of
Thrift Supervision from 1997 to 2001, contributed substantially to this
article.
--
Dan Clore
My collected fiction: _The Unspeakable and Others_
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Skipper: Professor, will you tell these people who is
in charge on this island?
Professor: Why, no one.
Skipper: No one?
Thurston Howell III: No one? Good heavens, this is anarchy!
-- _Gilligan's Island_, episode #6, "President Gilligan"