Too Many to Fail: Against Community Bank Deregulation

If there was one thing most people could agree on after the 2008 financial crisis, it was that “too-big-to-fail” banks were to blame for the market crash. This shared understanding was accompanied by a corollary: Small banks were not the problem. These so-called community banks were perceived to be innocent bystanders, overrun by market turmoil caused by much larger financial institutions.

Community banks have long been sympathetic figures in financial regulatory circles. Generally speaking, the term refers to banks with less than $10 billion in assets that focus on traditional financial products. Reasoning that such firms pose little risk, policymakers have frequently granted community banks special regulatory treatment. By the late 2010s, however, many observers concluded that the Dodd-Frank Act and other post-crisis reforms had inadvertently handicapped community banks, burdening them with unwarranted legal requirements and compliance costs. Across the political spectrum, policymakers agreed that community banks needed relief from Dodd-Frank in order to remain competitive.

This dominant narrative has now culminated in sweeping deregulation of the community bank sector. In 2018, Congress passed the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) with bipartisan support. The EGRRCPA and related rollbacks by the federal banking agencies eased capital requirements, loosened liquidity rules, and relaxed supervisory oversight of community banks. Small banks and their regulators proclaimed that these reforms would provide urgently-needed regulatory relief and help community banks meet their customers’ financial services needs.

Our new article, Too Many to Fail: Against Community Bank Deregulation, challenges the conventional wisdom that led to this comprehensive deregulation. It is the first legal scholarship to scrutinize the widely accepted justifications for easing regulatory burden on community banks. As we demonstrate, the leading rationales for rolling back community bank safeguards are deeply flawed.

First, contrary to popular belief, community banks can propagate systemic risk. That is because, when community banks fail, they do not collapse in isolation. Rather, they  tend to fail en masse due to their highly correlated balance sheets and funding strategies. And when many community banks fail simultaneously, small businesses, homeowners, and local communities lose access to needed financial services, further damaging the economy. This dynamic, which we call the “too-many-to-fail” problem, has occurred in every banking crisis in U.S. history, up to and including the 2008 crash.

Second, Dodd-Frank and other post-financial crisis reforms did not uniquely burden community banks. To the contrary, policymakers exempted community banks from the most significant Dodd-Frank rules. While some one-size-fits-all post-crisis rules do apply to community banks, regulators minimized the burden on smaller firms by setting easily achievable standards and publishing special compliance guides. Moreover, several provisions in Dodd-Frank introduced generous subsidies for community banks that more than offset compliance costs attributable to the most onerous post-crisis rules. Thus, the consensus view that post-crisis reforms unduly burdened community banks is seriously mistaken.

Third, community banks do not require regulatory relief in order to compete with larger financial institutions. In fact, community banks’ market share has increased since the financial crisis, and they remain just as profitable as they were before Dodd-Frank. Proponents of regulatory relief point to a sharp drop in the number of community banks as evidence that Dodd-Frank disproportionately impaired smaller firms, but this too is misleading. Upon closer examination, the steady decline in the number of community banks predates Dodd-Frank and is more attributable to macroeconomic conditions following the crisis than to excessive regulatory burdens.  The economic case for community bank regulatory relief, therefore, has been vastly overstated.

Despite the limited legal and empirical support for deregulation, the pervasive myths about community banks have gained acceptance not only in policymaking circles, but also in legal scholarship. Of the handful of financial regulatory scholars who have written about community banks, all have endorsed the popular narrative that post-crisis regulation unfairly penalized smaller firms and should be relaxed. By contrast, we argue that the EGRRCPA’s community bank deregulation will increase systemic risk in the banking sector.

For example, as a result of the recent regulatory rollbacks, community banks are more likely to invest in riskier assets and rely on more volatile sources of funding. Excessive risk-taking, meanwhile, will escape supervisory scrutiny because the EGRRCPA curtails regulatory reporting and oversight for these same institutions. Furthermore, new corporate governance rules will allow hedge fund and private equity investors to exert greater control over community banks’ corporate governance, leading to even more risk-taking. In combination, therefore, these reforms are likely to increase the fragility of the community bank sector and intensify the too-many-to-fail problem.

Moreover, as a consequence of the EGRRCPA, riskier financial activities should be expected to migrate to smaller banks over time as market participants engage in regulatory arbitrage. This conclusion follows from basic economic and financial theory, which predicts that risk-taking tends to shift from well-regulated to less-regulated sectors. Consistent with the logic of regulatory arbitrage, early evidence suggests that community banks have already begun to absorb a greater share of financial risk as a consequence of Dodd-Frank’s emphasis on regulating the too-big-to-fail megabanks. The EGRRCPA will accelerate this pattern of regulatory arbitrage, since community banks no longer face risk-based capital requirements, annual supervisory examinations, or limits on volatile funding. Thus, while the effects of the EGRRCPA might not materialize immediately, the statute’s sweeping deregulation of community banks may ultimately hasten the next too-many-to-fail crisis.

As a policy response, we recommend three measures to combat the looming too-many-to-fail problem. First, policymakers should repeal the EGRRCPA and related deregulatory initiatives.  Second, the financial regulatory agencies should use their supervisory authority to closely scrutinize community banks near the $10 billion asset threshold – a highly salient regulatory cliff where many post-crisis legal restrictions go into effect. In light of the new opportunities for regulatory arbitrage, risks have already begun to concentrate in banks just below the $10 billion threshold, and supervisors should target their oversight accordingly. Third, the federal banking agencies such as the FDIC should perform periodic, sector-wide stress tests of community banks as part of their macro-prudential efforts coordinated through Dodd-Frank’s Financial Stability Oversight Council. Unlike Dodd-Frank’s institution-specific stress tests for too-big-to-fail banks, sector-wide stress tests would assess the health of the community bank industry as a whole and attempt to identify common vulnerabilities across institutions. Collectively, these reforms would make the community bank sector more robust to macroeconomic volatility and help alleviate the too-many-to-fail problem.

To be clear, our objective is not to stifle community banks with excessive regulation. Instead, these recommendations aim to preserve the long-term viability of the community bank sector. Unlike big banks, which usually rely on standardized mathematical models when underwriting loans, community banks specialize in relational lending. That is, they use soft information – drawn from their familiarity with their local customer base – to extend loans to creditworthy small businesses and entrepreneurs that big banks traditionally would not support. For this reason, community banks are critical to long-term economic growth. Our aim, therefore, is to better align the regulation of this profitable yet fragile sector with the goal of maximizing lending throughout the business cycle, rather than just in the near term.

This post comes to us from Jeremy C. Kress, assistant professor of business law at the Stephen M. Ross School of Business at the University of Michigan, and Matthew C. Turk, assistant professor of business law and ethics at Indiana University’s Kelley School of Business. It is based on their recent article, “Too Many to Fail: Against Community Bank Deregulation,” available here.