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Financial Services | More Regulation, Fewer Community Banks

By Chris Clair


Dodd-Frank financial oversight reform legislation has taken a toll on Kentucky’s community bank numbers since its 2010 passage in response to the near collapse of the nation’s financial industry in late 2008.

While mitigation measures are finally showing signs of life in Congress, roughly 15 percent of depository institutions in Kentucky – 33 banks – closed between the end of 2009, the year before Dodd-Frank passed, and March of this year, according to the state’s Division of Depository Institutions, which supervises state-chartered banks. In 2016 five banks closed. Already this year four have.

As its rules have been developed, the federal legislation has required Kentucky bank owners to put more capital into institutions, increased compliance obligations that increased their costs, but made it harder for them to qualify borrowers for the loans that create income.

Kentucky bankers have been among the years-long chorus calling for easing, if not full repeal, of Dodd-Frank’s burdens. However, despite Dodd-Frank critic Donald Trump’s win in the 2016 presidential election, which kept anti-regulation Republicans in control of Congress, they are not optimistic this will happen soon.

Ballard Cassady Jr., president and chief executive of the Kentucky Bankers Association, said there aren’t enough votes in the U.S. Senate to repeal Dodd-Frank. What’s more likely, he said, is that either Trump will try to chip away at the rules through executive orders, or Republicans in the House and Senate could make changes through the budget reconciliation process.

“Any of those would be just a handful of things,” Cassady said. “It would not be anywhere near what the industry needs to get back to serving their communities.”

Consolidation is creating most of the Kentucky banking closures. Institutions are merging with or acquiring other in-state banks in most cases, but banks in Ohio and Indiana are also targeting Kentucky banks.

Not all of those closures were due to increased regulatory reporting requirements and regulations that restrict lending. Kentucky has seen sluggish economic growth coming out of the Great Recession due in part to the loss of coal jobs in Eastern Kentucky. That’s increased loan delinquencies and foreclosures in that area, putting added pressure on local banks.

Relief for smaller banks first

At the top of changes state bankers would like to see are passage by Congress of the TAILOR Act and the relaxing of certain portfolio lending rules for loans that banks keep on their own books. Its aim is to alleviate the perceived one-size-fits-all regulatory regime and ease the compliance burden for smaller banks.

Co-sponsored by Kentucky 6th District U.S. Rep. Andy Barr, the TAILOR Act (H.R. 1116) would require federal financial agencies to take into account the risk profiles and business models of the institutions they oversee when taking regulatory action. It would require those agencies to consider various costs and other impacts for those institutions.

The TAILOR Act has been referred to the House Financial Services Committee, on which Barr sits.

Critics say the law goes too far and would also relax rules on big banks, and that the Consumer Financial Protection Bureau already has the discretion to ease rules on smaller banks.

The goal of its portfolio lending rule changes is to make it easier for community banks to lend money to people who might not otherwise qualify for loans, provided the banks keep those loans – and all of the risk associated with them – on their books and not sell them or securitize them.

Barr introduced a bill in 2015 that would have made those changes, and it passed the House before stalling in the Senate. Critics contended it went beyond just helping small banks. President Obama had indicated he would likely veto the legislation.

At the time, Barr said the Qualified Mortgage rule was a cause of banking industry consolidation and closures of community banks and credit unions.

Luther Deaton, chairman, president and CEO of Lexington-based Central Bank, said the lending rules handcuff community banks, preventing them from making loans to customers they know can pay them back. The negative effect is twofold: The customers end up looking for loans from less reputable lenders with less favorable terms, and local economies suffer because bank lending is restricted.

“If they don’t change something, you could see small banks in small communities merging with somebody else in another community and leaving,” Deaton said. “And that community has no banks to deal with. A community bank is the heart of every community.”

Cassady said that’s already happening.

“We’ve lost 30 banks in the last 10 years,” he said. “All but one of them closed down because of compliance costs. When I say ‘closed down’ I mean they sold or merged with someone else because they couldn’t stay independent.”

Many of the bank closures recorded by the Division of Depository Institutions were related to regulatory requirements placed on smaller banks by Dodd-Frank rules, said Cassady, who is no fan of Dodd-Frank or the Consumer Financial Protection Bureau that it created.

Fewer banks a national trend

Kentucky is part of a national trend of shrinking bank numbers. During the past 20 years the number of FDIC-insured commercial banks in the U.S. has fallen 46 percent. From 2010, just as the Great Recession had ended officially, through 2016 the number of FDIC-insured commercial banks in the United States declined 22 percent, from 6,519 to 5,113.

Looking at FDIC statistics, an argument can be made that the decline in institutions was a thinning of the herd of sorts. More of the remaining banks are profitable – and more profitable, with higher returns on equity and assets than in 2010. The number of failed institutions has dropped each year since 2010, when 139 institutions failed. Five did in 2016.

According to FDIC data, of the 518 bank failures that occurred nationally between 2008 and this year, only two were in Kentucky – Irwin Union Bank in Louisville in 2009, part of a broader failure of Irwin Union Bank due to bad home mortgages – and First Federal Bank in Lexington in 2013, a result of high default rates on loans.

At the same time, since Dodd-Frank became law the number of new bank charters recorded by the FDIC has flatlined. Between 1997 and 2009, the FDIC recorded an average of 143 new bank charters per year. There was near total collapse between 2009 and mid-2016, the most recent figures available, as the FDIC recorded a total of seven new charters: five in 2010, one in 2015, and one in 2016. None of those were in Kentucky.

While the period since 2009 includes the Great Recession and its aftermath, which has seen slow economic growth, Cassady says some of the lack of bank growth is most certainly due to the regulatory environment.

Compliance creates personnel costs

Although the number of banks in Kentucky has declined 15 percent since the end of 2009, the number of employees at banks in the state increased by 3 percent, perhaps a reflection of the additional compliance positions required to keep up with federal reporting requirements.

Of 200 small banks in 41 states surveyed in a 2014 study by the Mercatus Center at George Mason University, 90 percent said the Dodd-Frank rules that had been finalized up to that point were increasing compliance costs, and 83 percent said the rules had increased costs by more than 5 percent. Almost two-thirds of banks said they would be changing the “nature, mix and volume of mortgage products and services as a result of new regulations” while 10 percent said they anticipated discontinuing residential mortgages. And despite the fact that the Consumer Financial Protection Bureau was supposed to concentrate on banks of $10 billion-plus in assets, 71 percent of the small-bank respondents said the CFPB was affecting their business activities.

Most of Kentucky’s 164 banks are “community banks” with $1 billion or less in local assets and are part of holding companies with less than $10 billion in total assets. This generally means they are local banks that serve local customers. A variety of factors go into designating a bank a “community” institution, including total assets, territory, loan-to-asset ratios, and core deposits-to-assets ratios.

Kentucky banks have an average of about $348 million per institution, according to FDIC statistics. That “community” threshold is important in the Dodd-Frank world, since banking organizations with less than $10 billion are supposed to be subject to less regulatory scrutiny.

In practice, smaller banks have been subject to many of the same requirements as larger banks, Deaton said, and Central Bank has had to hire four people to work on compliance and auditing. He estimates Dodd-Frank has cost Central Bank $7 million a year net in additional staff and compliance costs.

Central Bancshares, the parent company of Central Bank, reported a 2016 profit of $17 million on non-interest income of $39 million.

“We’re blessed to do well,” Deaton said. “But if I didn’t have to do a lot of this crazy stuff I’ve got to do, I’d have more that I could invest back in my community and give to charities.”

Dodd-Frank’s origins

Understanding what increased bank regulation is doing to community banks starts with recalling the circumstances that led to the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Both started out in response to a credit crisis brought on by banks’ willingness to give mortgages to people who ultimately couldn’t pay them back.

Because of the way mortgage securities were and still are packaged together into bonds and sold into the financial system, the defaults of some mortgages infected outsized parts of the credit markets. When defaults began to increase, it triggered a domino effect through the entire financial system. Lehman Brothers, a 160-year-old global financial service company, collapsed in the largest bankruptcy in history, and 85-year-old Bear Stearns nearly did before the government forced its sale to JPMorgan Chase.

Investors panicked and started selling credit-based assets. The lack of credit market liquidity due to the massive redemptions crimped short-term lending that the private sector uses to fund operations and even make payroll.

Stock prices fell, home lending slowed to a crawl, and the U.S. economy entered a recession that resulted in hundreds of thousands of lost jobs.

In addition to the mortgage-based credit crunch, some bankers and traders in the United States and abroad routinely flouted regulations and bragged about it via email and instant messages.

Traders at dozens of banks around the world colluded for years to rig the London interbank offered rate, or LIBOR, which is used to benchmark international interest rates. In 2015, five banks – JPMorgan Chase, Royal Bank of Scotland, Citigroup and Barclays – pled guilty to manipulating foreign exchange markets and paid more than $5.5 billion in settlement charges. Separately, nine banks, including some of the same forex manipulators, settled civil charges that they manipulated currency markets. They paid $2 billion.

If ever there was a case of a few bad apples ruining the fun for everyone, banking is it. Kentucky’s community banks have been caught up in a massive regulatory overhaul, only part of which was designed to apply to them.

Reasonable people can debate whether Dodd-Frank and the regulations that eventually resulted were a response to the crisis or a response to the opportunity to rein in the financial sector that the crisis presented. At its heart, Dodd-Frank was an attempt to monitor and mitigate risks in the financial system that could lead to systemic failure of that system – too many risky loans, banks too big to be allowed to fail, too little reporting to regulators who didn’t always communicate.

The legislation left implementing rulemaking to the regulators. In total, Dodd-Frank required 390 new rules. As of the end of the third quarter of 2016, regulators had finalized 249 of those rules, according to law firm Davis Polk & Wardwell LLP, with another 58 proposed, leaving 83 rules yet to even be proposed.

Banks, their advocates and those opposed to Dodd-Frank naturally say the new regulations are costly and burdensome. Deaton and Cassady are among those, although Cassady faults the regulators for pushing down onto smaller banks regulations designed for larger banks and Deaton said Congress created the problem and is responsible for fixing it.

Deaton emphasizes that what’s needed is a fix for Dodd-Frank, not a repeal.

“I know some people want to do away with Dodd-Frank,” Deaton said, “I don’t want to do that. I just want to fix what’s broken so I can serve my customers, and serve my communities.”

Chris Clair is a correspondent for The Lane Report. He can be reached at [email protected].