Few will argue that a strong small business sector is a key component of America’s economic revival, yet the current economic climate is far from conducive to success.
A key impediment is the difficulty in obtaining funding to start or expand a small business. Those companies without certain sales milestones or who do not have sufficient collateral are unlikely to have much success walking into the local bank.
Sadly the local bankers know this. In the past the community banker knew many of the clients personally. Generations of the family had banked at the same place. Their families may have known each other through community or church involvement or they may have even been neighbors.
There was a time when a community banker knew that someone who may have raised a red flag on paper was more than a good risk. The applicant was a respected member of the community who would pay back the loan. The bank was not just investing in the business, they were investing in the person.
In the current era of consolidation, community bankers have lost much of that discretion. Leadership and targets now come from a head office which may be hundreds of miles or even states away. The person in charge of those numbers has no idea that John Doe’s family are longstanding community members who helped build the local ball diamond, fund scholarships and are genuinely good people. He or she probably does not care.
This leaves a funding void in most communities across the United States, one that used to be filled by community banks and which can be filled by them again. By using crowdfunding community banks can play the key role in small business funding that they successfully did for so long, but in a new way, according to a white paper published by investment portal Breakaway Funding.
Breakaway Funding is run by a team of community bankers who saw the effects the recession had on America’s small business community. They have written a series of three white papers collectively entitled Community Banks: Renewed Purpose and Survival Through Crowdfunding.
Part One, Banking with Purpose, provides a history of community banking, describes threats to the traditional business model, and suggests crowdfunding as a key step to their future prosperity. Crowdfunding101 for Community Bankers provides a primer for community bankers. The series concludes with Sink or Crowdfund outlines why community banks need to incorporate crowdfunding as a means of survival.
Breakaway Funding Founder and Managing Partner Kim Kaselionis and CommunityLeader CEO Joseph Barisonzi wrote the series and took some time to answer questions about crowdfunding, community banking and how the two fit together. Get more information on the actual reports by clicking here.
1. Your paper mentions the FDIC acknowledges that one of the defining characteristics of community banks is the activities they engage in, yet by increasing the regulatory burden, agencies like the FDIC are making it harder for them to engage in such activities. Is this a fair statement?
Absolutely. To the extent that bankers are weighed down with an ever-increasing onslaught of regulations, they have less and less time to be engaged with their clients and communities.
However, in her comments of May 1, 2014 at the Independent Community Bankers of America 2014 Washington Policy Summit (Washington, D.C.), Fed Chair Janet L. Yellen made statements suggesting that regulatory agencies are aware of the impact their policies have on community banks and have taken/plan to take steps to alleviate the regulatory burden by tailoring supervisory expectations and approaches to the specific circumstances of community banks.
No one can say for sure how this will play out… I hope so, but my past experience as a community banker leaves me skeptical.
2. Lending criteria are getting more stringent, yet banks are sitting on large reserves that are badly needed to help stimulate the economy. Who are getting squeezed the most by this and what can be done to encourage banks to put those funds into circulation? The short answer is, “everyone.”
One of the first economic pains to result from a stagnant economy is an increase in unemployment due to job loss and the negligible creation of new jobs. Without income, individuals obviously can’t pay their mortgages or purchase goods and services. This, in turn, has a negative impact on business revenue-generating opportunities.
The job creation and purchasing of capital goods that would have resulted from those opportunities is then lost as well.
Communities suffer when real estate values decline due to foreclosures. Not only are people left without homes, but foreclosures and declining real estate values result in the loss of tax revenue, much of which is used to hire and maintain public employees.
With fewer public employees, fewer services can be provided to the community (i.e., fire, park, police). The simultaneous increase in unemployment claims and decrease in public services results in higher crime rates and mounting pressure on non-profits to provide the services previously provided by government programs.
So my answer to “who gets squeezed” is: individual citizens, families, businesses, communities, government services, non-profits—everyone.
With respect to encouraging banks to put funds into circulation, I have a few thoughts as follows:
1) Educate bankers on how they can leverage changes in the securities market to deliver more capital to SMBs. For example, around the time the bank I lead was sold (2012), I attended an economic conference at Sonoma State University. One of the panelists talked about equity crowdfunding and the JOBS Act. As the CEO of a community bank, all I could think of as I listened was: What a great way for banks to leverage Title III to get more capital to their commercial clients. One idea that came to mind was to create a new loan program that matches (at some ratio greater than 1-1) the amount of equity a business owner can raise via crowdfunding. A new ”3-for-1” loan program, for example. For every $3 in equity raised by business owners through their customers, suppliers, vendors, and other relationship, the bank would lend $1. The amount of equity raised by the entrepreneur strengthens the balance sheet and reduces the risk to the bank. This is a “win-win” for everyone. Businesses get capital to grow, prosper and create jobs. Communities see higher employment rates, mortgages are paid on time and property values increase, resulting in a higher tax base. The economic cycle feeds itself back to health.
2) State and federal loan guarantee programs need to be utilized more prevalently. States, like California, were granted funds through the JOBS Act to promote state guaranteed loan programs. Community banks should be taking advantage of these programs to get more capital to their business clients, while reducing risk of loss via the guarantee to the bank.
3) New market tax credits enable banks to tap into government programs by loaning money to various target groups/geographies. For example, there are four types of Economic Development Areas in California: Enterprise Zones (EZ), Local Agency Military Base Recovery Areas (LAMBRA), Manufacturing Enhancement Areas (MEA) and Targeted Tax Areas (TTA) in urban and rural areas. While I was the CEO at Circle Bank, we utilized the Enterprise Zone (EZ) program. When the bank lent money to businesses located within the boundaries of an EZ, the interest income earned from these loans was deducted as a credit from the bank’s reportable income.
3. You mention throughout the paper that many people are being discouraged from engaging in the activities that attracted them to community banking in the first place. If left unchecked, will that affect the types of people the industry can attract? What will the result be long-term?
Good question. As a former community banker, one of the most gratifying parts of my job was working closely with our business clients to support their success.
(The same is true for community groups, whether the Rotary Club, the Chamber of Commerce or the local non-profit.)
Whether this meant listening to the recent challenge they were encountering or had conquered, providing feedback on their current business opportunity, or getting an update on family members, what they valued most of all was our time together.
Beginning with the financial crisis, community bankers have experienced consistently increasing and conflicting demands for their time. Adding to the demands of the financial crisis, bankers have faced the increased regulatory burden of the past six years, heightened competition from large banks and non-banks, the constant battle to stay ahead of technological innovation and higher shareholder expectations for improved profitability. Community bankers now have so many demands jockeying for their time that the amount of time they spend with clients and community groups has, by necessity, has declined.
Add to this both the fact that the Board of Directors at many banks have reeled back individual lending authority and the fact that many community banks have been absorbed by their larger brethren (whose lending activities/authorities are most likely centralized out-of-state and certainly not locally). Faced with all this, the job of the community banker—to know and service their customers—is slowly disappearing.
With respect to what type of human capital the industry will attract, this remains to be seen. By and large (and in my recent experience), notwithstanding the curtailing of authority and autonomy in the space, there is still a hope and desire by bankers to fight to continue serving the critical roles they play in their communities.
As for the industry’s long-term future, we’ll have to wait and see on that as well. Having witnessed the integral role community banks play in their communities and in the banking industry as a whole, I believe that if the community banking industry fails to thrive, it will be a sad day for communities and individuals across the country.
This is the basis for our endeavor to educate community bankers about the benefits of implementing a crowdfunding strategy and doing so now. We want bankers to leverage all the tools they have available to them as they combat the assault of regulatory burden and competition within a framework consistent with their mission of “being for and of the community.”
4. Does community banking still have a significant place in rural America or is that changing too?
Yes. In a report by the University of Pennsylvania entitled “Challenges and Opportunities for Community Banks in Rural Pennsylvania”, the authors document the significant role of community banks in the economic growth of local communities in the commonwealth. Citing that the association is stronger in rural counties than in urban counties, they confirm that rural community banks play a critical role in their area’s local economic prosperity.
In another study, by the Center for Rural Development, the authors site that “approximately 40% of low-population, completely rural counties in the United States do not have a bank branch located in the county – documenting the need for community banks to continue to serve these communities. The challenge for bank, however, is that it is becoming more and more difficult financially for banks to continue to operate in smaller communities. The scale is too small to provide many of the products and services desired by small businesses, commercial farmers, and low and medium wealth residents who desire a bank or branch to be located in the county.
As I noted above in regard to government guaranteed loans, community banks in these areas have access to USDA guaranteed loan programs to support the local agricultural economy. We need to think differently about how we can engage collaboratively (perhaps regionally) to create new solutions for on-going challenges. The use of technology can also assist in continuing to provide financial services in these areas.
5. Can you give specific examples of how compliance and underwriting changes have increased the burdens on community banks?
At Circle Bank we saw our costs related to compliance more than double within just a few years due to the need to stay ahead of the compliance regulation curve. These costs involved not only hiring additional staff to implement internal processes, procedures and reporting, but also acquiring technology solutions to be more efficient in our compliance efforts.
In the white paper, we shared a graph which showed the survey results of bankers who were asked the question “has there been a change in your annual compliance costs since Dodd-Frank?” Eighty-three percent (83%) responded they have seen an increase of greater than 5% since Dodd-Frank.
Dodd-Frank Act alone is over 14,000 pages. As someone once put it, “Rules implementing the Dodd-Frank financial reform law could fill 28 copies of Leo Tolstoy’s War and Peace.”
All told, regulators have written 13,789 pages and more than 15 million words to put the law in place, which is equal to 42 words of regulations for every word of the already hefty law, spanning 848 pages itself. In addition, according to Davis Polk law firm, the work of implementing the law was just 39 percent complete as of July 2013, three years after the act was passed. Dodd-Frank is, of course, only one set of relatively new regulations that now factor into existing banking law.
Along with Dodd-Frank there are the Bank Secrecy Act (BSA), designed to keep tabs on currency transactions, prevent against and report on suspected criminal activities, and the Community Reinvestment Act (CRA), which encourages depository institutions to help meet the credit needs of the communities in which they operate, including low- and moderate-income neighborhoods. It encourages this while also demanding that banks be consistent with safe and sound operations. This presents quite a paradox, since lending to low-moderate income constituents presents, by definition, greater risk.
Most banks have two sets of regulators: federal and state. In some cases, if there is a bank holding company, there is a third regulator. Banks are subject to three types of examinations: Compliance, CRA and Safety and Soundness, which includes an IT exam and BSA exam. At any given time, a community bank is either in, preparing for or completing at least one examination. Depending on the size of the institution, banks can host upwards of a dozen examiners during any one of these examinations.
With respect to underwriting, while banks are beginning to lend again, the flexibility they once enjoyed, has been replaced with more stringent underwriting policies and guidelines. Less lending means more liquidity, which reduces profitability. Reduced profitability increases shareholder concerns and reduces the capital base on which asset growth is leveraged.
6. Why did legislation to protect community banks fall so short?
My experience is that, many times, legislation has unintended consequences, such as the cost of implementation, including the expense of technology enhancements needed to facilitate compliance, insurance costs, and the human capital costs necessary to adhere to and report on the compliance efforts.
7. Since Dodd-Frank in 2010, banking assets and domestic deposit shares are both down substantially. What specifically did Dodd-Frank do to contribute to this?
With regard to Dodd-Frank, I have found that my colleagues in the community banking sector have had experiences similar to my own. The recent testimony of Thomas Boyle, Vice Chairman of State Bank of Countryside (Illinois), communicates a typical banker’s experience:
“We strongly believe that our communities cannot reach their full potential without the local presence of a bank that understands the financial and credit needs of its citizens, business, and government. However, I am deeply concerned that this model will collapse under the massive weight of new rules and regulations… Banks are working every day to make credit and financial services available. Those efforts, however, are made more difficult by regulatory costs and second-guessing by bank examiners. Combined with the hundreds of new regulations expected from the Dodd Frank Act, these pressures are slowly but surely strangling traditional community banks, handicapping our ability to meet the credit needs of our communities. The consequences are real. Costs are rising, access to capital is limited, and revenue sources have been severely cut. This means that fewer loans are being made. It means a weaker economy. It means slower job growth. “
While Dodd- Frank makes an effort to roughly distinguish between banks on the basis of size, excluding financial institutions with assets of less than $10 billion from some rules, it will still have a significant impact on community banks. Dodd-Frank is a massive and complicated piece of legislation (16 titles over 838 pages), the consequences of which will not be known for many years since it relies so heavily on rule-making by regulatory agencies.
One reason this is important is that our policy choices have a real impact on the market and the ability of these regulated financial institutions to compete within it. Seven of the 16 titles of Dodd-Frank are expected to impact community banks. Hundreds of regulations are yet to be promulgated. Most of these rules are complex, and the costs of understanding and then complying with them will be extremely high. A $165 million bank is less able to absorb regulatory burden than a $2 trillion bank. By imposing unnecessary regulations on smaller institutions, we are awarding the larger banks a further competitive advantage.
At least one leader of a “systemically important” financial institution has acknowledged that the costs of complying with Dodd-Frank will increase the competitive advantage of large banks to the detriment of community banks. While Jamie Dimon, President/CEO and Chairman of JP Morgan Chase, has estimated that the cost for JP Morgan Chase to comply with Dodd-Frank will be “close to $3 billion” over the next few years, a February 2013 note to clients from Citi financial services analyst Keith Horowitz tells a slightly different story.
In his note, Horowitz described a conversation with Dimon regarding the impact of new regulations on the financial services sector. According to Horowitz, during that conversation Dimon predicted that JP Morgan Chase’s market share would grow due to the fact that reforms “make it tougher for smaller players.” As Dimon acknowledged, Dodd-Frank has the potential to have a very costly impact on community banks, threatening their ability to compete and accelerating the pace of mergers and acquisitions. As a result of this competitive disadvantage, rather than strengthening the safety and soundness of the American financial system and protecting consumers, Dodd-Frank may ultimately create several new problems for the American economy.
The testimony goes on to suggest that Dodd-Frank will lead to greater asset concentration in a smaller number of financial institutions. For the past several decades, bank consolidation and asset concentration has increased dramatically in the American banking sector.
We refer you to the graph titled “Share of Total US Banking Assets held by Five Largest Banks v Small Banks” reproduced in our white paper.
8. The housing slump in the middle of the last decade was exacerbated by tougher restrictions on construction and development loans. I find that ironic given lack of oversight on various big bank loans was a major cause of the recession. Is there a double standard in oversight?
Probably. The double-standard, however, may be the result not of deliberate discrimination, but for other reasons: the complexity and shear size of big bank balance sheets, by their very nature, can present a variety challenges to regulators; smaller bank balance sheets are fairly simplistic or “vanilla.”
It is a lot more difficult for smaller banks to “hide” or “mask” problems even if problems exist. There just isn’t that much to examine in the first place. Perhaps, “too big to fail” is “too big to regulate” effectively and equitably.”
9. Is today’s housing market still hurt by this?
Data from the FDIC indicates that smaller financial institutions, typically community banks, are the most common sources of lending for home building acquisition, development and construction (AD&C) loans.
However, according to the household component of the April 2014 Senior Loan Officer Opinion Survey on Bank Lending Practices (released by the Federal Reserve Board), banks eased their lending standards for auto loans and credit cards. At the same time, a net share of bank officers reported having observed rising demand for auto loans and credit cards.
In contrast, a net share of bank officers reported that their bank had tightened lending standards on prime residential mortgages and a net share reported having observed a decline in demand for prime residential mortgages. So, yes, I believe the housing market still suffers today.
While smaller community banks have been the most common source for lending for home building acquisition, development and construction loans, there is not sufficient volume to “move the needle.”
10. Your paper discusses how community banks have to maintain certain levels of reserves. Larger banks supposedly have to do this, but have more avenues at their disposal to keep those levels lower due to the exclusion of certain product classes. Is this too a double standard?
You can make that call. Suffice it to say, there are structural balance sheet differences given even just the size difference between large and small institutions.
11. What specific solutions does crowdfunding offer community banks? Should they facilitate loans/partner with someone a la Prosper and Lending Club, or should they develop a portal or work with someone along the lines of Kickstarter or Indiegogo?
These complex questions demand in-depth explanations, which is why we’ve chosen to address the topic through a series of white papers rather than a single piece.
This way we’re able to provide community bankers with the level of detail and understanding they need to make informed decisions and communicate these decisions to other people.
The second paper will be available shortly and the third will be published by the end of the month. Please also visit our website to sign up for notices regarding future publications at www.breakawayfunding.com/forbankers.