Small banks face unique business circumstances and policy needs

The Dodd-Frank Act includes a variety of provisions that, in both purpose and effect, create special benefits for community banks. None of those provisions, though, address community banks’ core structural challenge:  they are increasingly confined to the most volatile corners of the credit markets. 

The crisis magnified -- it did not create -- the challenges facing  community banks.  Although the variety of bank rescue programs disproportionately benefited the largest “too big to fail” institutions, small banks’ woes did not begin, nor have they ended, with the financial crisis. This is because small banks and their larger competitors are fundamentally different from one another. They do not face the same structural challenges, for they differ in personnel, history, and business strategy.

Legislation should view small and large institutions through distinct lenses. The late 1990’s reforms, culminating in the 1999 Gramm Leach Bliley Act, have not enabled small banks to enter scale-intensive (but capital-efficient) fee businesses -- those benefits have accrued almost entirely to large banks.  At the same time, small banks have found it difficult to efficiently originate credit risk for their traditional balance sheet lending.

When making policy, it is essential to understand that small banks and large banks need to be viewed as separate industries that face largely disparate challenges. A combination of market and regulatory forces has increasingly confined small banks to commercial real estate and construction lending. These particularly volatile asset classes make it difficult for  geographically constrained firms to safely hold these assets through the cycle. The plight of small banks is different from the immediate challenges facing the largest financial institutions.  Policy makers should not expect the same protocol to equally impact these dissimilar entities.