Basel III Hurts Community Banks and Consumers

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Have an account at a community bank? If you do, your bank may not be around for much longer. This is not because community banks have overleveraged themselves, made bad bets on derivatives, or loaned money to people who couldn't pay it back. Rather it's because they are feeling the pressure of the federal government's grip in the form of Basel III, the international banking regulatory regime developed in the wake of the financial crisis that the U.S. agreed to implement.

The Dodd-Frank Act, the administration's vehicle of choice for implementing Basel III, mandates the FDIC, Treasury Department, and the Office of the Comptroller of the Currency to establish minimum risk-based capital requirements for banks. Through these capital requirements, the agencies expect the threat of systemic risk in the banking system to be reduced by forcing banks to have more capital buffers for riskier assets. But is a one-size-fits-all system that treats small community banks the same way as internationally active, Wall Street megabanks the best approach? No. It is not fair to the banks and it is not fair to consumers.

Community banks are generally defined as banks with less than $1 billion in assets. There are approximately 6,800 community banks which represent about 8% of total assets in the banking sector, but they account for almost 40% of all small business loans. The proposed Basel III regulatory capital requirements are an immense and unnecessary burden that will actually threaten their existence. Community banks were already having a hard time re-establishing themselves in a period of weak loan demand, low interest rates, and thinning profit margins. In 2011, only 3 new community banks were chartered, down from 181 new charters in 2007.

But these new regulations will further drive consolidation between them into bigger banks. Community banks that can't find affordable ways of raising capital will be left without many options other than to find a merging partner. Some on Wall Street, like mergers and acquisitions expert John Slater, predict that Basel III's compliance costs will lead to a merger boom, and that in the next 3-5 years 20-30 percent of all banks will merge.

Beyond billions of dollars in capital requirements, there would be other compliance costs too -- such as salaries for compliance officers, compliance training, legal services, compliance software, IT expenses, and record keeping services. William Grant, Chairman and CEO of First United Bank and Trust, a community bank with $1.38 billion in assets, testified before the House Subcommittee on Financial Institutions and Consumer Credit that that his bank would need to spend at least $2.5 million per year on added compliance costs as a result of Basel III. Grant also pointed out that the cost of regulatory compliance, as a share of operating expenses, is two-and-a-half times greater for small banks than for large banks.

H&R Block, the largest tax preparer in the United States, also runs a small banking operation, which it is currently trying to unload as a result of the looming regulations. In a regulatory filing H&R Block baldly stated: "Such regulatory constraints are inconsistent with our strategic plans, operational needs and growth objectives."

But even the community banks that manage to survive the new capital requirements and compliance costs might not be safe for too long. Other Federal Reserve policies and maybe even more regulations in the future could kill off the ones that remain. For example, Ronald Bowden, the chairman and CEO of Iowa-Nebraska State Bank, has noted that rising interest rates could significantly hurt community bank capital positions because a 3% upward swing in interest rates could drop a bank's Tier 1 capital ratio (the core measure of a Bank's financial strength from a regulatory point of view) by 30%, placing the bank in a stressed position.

Greater consolidation will mean fewer options for consumers and higher prices. Chris Cole, senior vice president and senior regulatory counsel for the Independent Community Bankers of America, notes that consumers will face higher rates on loans, lower rates on deposits and likely more fees. According to a 2004 Federal Reserve study, community banks have fewer fees than larger banks. Non-interest income (fees and other service costs) at banks with less than $1 billion in assets accounts for only about $1 in every $5 of operating income, while in banks with at least $25 billion in assets, fees account for about $1 in every $2 of operating income.

Beyond higher prices, consumers will potentially face worse service for large, anonymous megabanks perhaps not understanding local needs as well as community banks that are closer to the customers they are serving. Unlike many large banks that may take deposits in one state and lend in others, community banks channel most of their loans to the neighborhoods where their depositors live and work. They are much more amenable, for instance, to offering small business and mortgage loans, which keep the community vibrant and growing. Certain community banks also offer vital products that larger banks in certain regions don't such as farm loans and mobile home loans. Community banks focus attention on the needs of local families, businesses and farmers. Conversely, many of the nation'smegabanks are structured to make large corporations a priority.

Community banks are small banks and do not pose the same kind of "systemic risk" to the financial system that larger megabanks do. It's not that community banks are "better" than megabanks, and thus don't need to be regulated. It's that the regulations have to be specific to them. A one-size-fits-all approach to capital requirements is unfair and undesirable.

It would be one thing if the megabanks were to outcompete the smaller banks by providing better products and services. But it's quite another when they win because regulations crippled their smaller competitors -- especially when these regulations were meant to reign in the risk they, not community banks, posed. Basel III may end up creating even more megabanks, exacerbating the very risk it was supposed to address.


Victor Nava is an economic research assistant at Reason Foundation.

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