A recent study from the Harvard Kennedy School takes a closer look at the long-term plight of community banks (defined as banks with less than $10 billion in assets) in the U.S. Authors Marshall Lux and Robert Greene examine the issue using FDIC data to analyze the factors behind the decline in community banking — including over-regulation — and suggest policy alternatives that could help the community banking industry get back on its feet.

U.S. Community Banks

Overview of community banks in the U.S.

The study highlights that despite community banks’ share of the U.S. bank-lending market declining by 50% over the last 20 years, community banking still plays a vital role in important lending segments. For example, community banks provide 77% of agricultural loans as well as more than 50% of small business loans. Farm lending requires a region-specific knowledge of agriculture and farming, and a longer-term perspective as  agricultural cycles are typically several years long. Community banks are also typically heavily involved in local real estate lending, especially residential real estate, where once again knowledge of local conditions and borrowers is critical.

Of note, the default rates for loans secured by one-to four-family residential properties were 3.47% for small community banks (with $1 billion or less in assets) compared to 10.42% for larger banks with over $1 billion in assets.

U.S. Community Banks

U.S. Community Banks

Crisis in community banks

Lux and Greene highlight the growing crisis in the community bank sector. The lending market share of community banks has dropped from above 40% in 1994 to around 20% at the end of 2014. Of note, community banks came out of the financial crisis with a 6% decrease in market share, but since the the passage of the Dodd-Frank Act, their share of U.S. commercial banking assets has declined at a rate almost double that between the second quarters of 2006 and 2010.

The authors note: “Particularly troubling is community banks’ declining market share in several key lending markets, their decline in small business lending volume, and the disproportionate losses being realized by particularly small community banks.”

U.S. Community Banks

Small Business Loans

Steps toward solving the problem

Given that the key issues facing community banks are inappropriately designed regulation and inadequate regulatory coordination, Lux and Greene suggest that thoughtful regulatory reform could solve many of the problems behind the community bank crisis.

They suggest that: “Improving federal regulators’ cost benefit analysis through non-binding OIRA review would enable regulators to achieve intended goals more efficiently and at lower costs to community banks.”

Post-crisis mortgage

U.S. Community Banks

The authors also argue Congress should act to improve existing regulations by introducing OIRA review to financial regulations and setting up a bipartisan commission to streamline financial regulations.

Last but not least, Lux and Greene say that regulators such as the “FSOC and the CFPB must improve structurally and culturally in order to more adequately monitor the effect of rulemakings on community banks. Policymakers should also examine simpler capital rules and various rule exemptions for community banks.”

U.S. Community Banks

See full PDF below.