How to Help Small Banks

Community service.

Photographer: Kevin P. Casey/Bloomberg

Legislators say they want to clear an obstacle to U.S. prosperity: burdensome regulation of the community banks on which much of small-town America relies. It's a worthy goal, but Congress isn't pursuing it the right way.

Typically defined as institutions with $10 billion in assets or less, community banks have recovered from the crash of 2008 more slowly than their larger counterparts. Thanks to mergers and a dearth of new entrants, there are fewer of them -- 6,410 in December 2014, down from 8,425 in December 2007. Their lending has rebounded lately, but still not to pre-crisis levels. It matters, because they account for about two-thirds of small-business loans and a quarter of mortgages.

Legislators such as Alabama Senator Richard Shelby, chairman of the Senate Banking Committee, are proposing lighter regulation. They want to tweak the 2010 Dodd-Frank financial reform law, partly by exempting some banks from the Volcker rule, which forbids speculative trading at federally insured institutions. They also want to raise the asset threshold -- currently $50 billion -- above which banks face added supervision.

These ideas are mostly beside the point. Most community banks don't do the kind of securities trading that the Volcker rule covers, and they have assets well below the current threshold, so the proposed changes just won't make much difference. Some regulators -- notably Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corp. -- therefore suspect that the real goal is to chip away at rules affecting the soundness of the country's biggest and most systemically important institutions.

If he's right, that's unfortunate -- not least because small banks really do suffer unduly from some of the rules aimed at large institutions. Take the requirement that banks sort their assets into myriad risk categories when calculating how much capital they need. Such risk weighting serves little purpose for small banks, which tend to be simple businesses that examiners understand well. Even so, it has contributed to a near doubling in the length of reports they must file with regulators every quarter.

There's more. New mortgage rules, which narrowly define how lenders must verify a borrower's ability to pay, are complicating the kind of "know your customer" lending in which community banks excel. As a result, small banks are balking at loans they used to make readily -- say, to a newly hired foreign college professor who lacks a local credit history, or to a doctor with a lot of student debt but excellent earning potential.

The Consumer Financial Protection Bureau is demanding more "fair lending" data on every application the banks receive, increasing the chance of errors that could get them in trouble with regulators, and even with the Justice Department. The banks also face a three-day deadline for responding to mortgage applications. This leaves little time to estimate costs for services such as appraisals -- and if they guess too low, they have to pay.

Community banks should be exempted from risk weighting as long as they have no significant trading or derivatives operations, get high grades on examinations, and maintain capital above a certain level -- say, a tangible common equity ratio of at least 10 percent of assets, a standard that more than half of them already meet. They should be free to make mortgage loans to any borrowers they deem creditworthy, provided they keep the loans on their books (even during the financial crisis, delinquencies on such loans typically didn’t exceed 1.5 percent). Examiners should be given more leeway in judging anomalies in fair-lending data, and banks should be given more time to process applications.

For small banks, require adequate capital, then emphasize simplicity and flexibility. That formula wouldn't compromise safety, and it would strengthen a part of the financial system that has to work well for the economy to thrive.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net.