The Small Town Bank

Small town banks really have had it tough. It has always been hard for them because of the mega trends of people moving away from small towns to the city, but there are other challenges that lurk around every corner.

The big decider for small town banks in the past ten years was Dodd-Frank. Dodd-Frank absolutely crushed community banking. The major domo regulations that government threw at the banking system to punish it in order to deceive the public from the real problems were unaffordable to community banks.  However, the tidal wave that upset community banks was rooted in public policy prior to Dodd-Frank.  Dodd-Frank was the nail in the coffin.

To give you some sense of the changes, here is a quote from the WSJ article I linked to above:

The 4,600 U.S. banks with $1 billion or less in assets—small community banks—today hold 6.6% of all bank assets combined. Three decades ago, around the time new laws spurred industry consolidation, they held 31.5%.

At our fund, we really keep a very close eye on banking and banking trends. It’s one aspect of our core investment thesis.  We have looked at a lot of tech in the banking sector.  We are invested in FinMkt, which is on the periphery of bank lending.

There are a couple of challenges that we have seen for startups entering this area.

1. The regulators enforce the status quo.  If I am a bank and the regulator comes in, I want as little disruption as possible.  When the regulator asks, “What core banking code are you using?” and the small bank lists off one of the big four bank code providers, the regulator moves on.  If they were to say, “We just started using this cloud based startup banking code that really allows us to innovate cheaply and service our customers better” the regulator is going to prop up the hood and stay a long time to make sure that everything is right.
2. Dominant Bank Code Companies Have an Oligopoly.  It’s very hard to compete.  One reason is the first one I listed.  The other problem for startups is to generate new bank code and get approved they have to go through a minefield of regulators.  It’s not as if you can just hack together something drinking a bunch of Red Bull in a dorm room over the weekend.  Going through regulation costs big time money.  Few investors have the appetite to undertake that with the uncertainty that the company will even make it.
3. Banks can’t go down.  Banks have to operate 24/7.  To switch to new technology, they need to run it parallel to existing tech.  That can more than double the cost to switch to the new technology.   For JP Morgan, not as big a deal because they can scale the cost across a large organization.  Community banks bear the entire brunt of the cost at one or less locations.
4. Access to outside capital.  Very difficult for community banks to access the public market.  They are backed by private investors.
5. State vs Federal Regulators.  States can pass onerous regulations or not.  Sometimes there are conflicts between the two regulatory systems that increase costs.
6. Technology costs are ballooning.  Bank of America spent $22 billion on tech in the last six years.
7. Profit margins are decreasing.  Customer acquisition costs have gone up.  The cost to operate the back office haven’t gone down.

Why is this an issue?  Does it even matter?  I mean, a bank is sort of a commodity business when you think about it.  Is there really a difference to the average consumer from Bank of America or JP Morgan?  Not really.  However, when we think about business banking there are huge differences.

First, think about some free market economic principles.  Here are some of many that come into play.

•  Competition.  Competition is really good and the existing climate takes a lot of the juice out of the competitive environment.
• Dispersion of power is a good thing.  As Milton Friedman wrote, ” to exercise power, better in the country than in the state, better in the state than in Washington”.  Adam Smith talked about the division of labor and the invisible hand of competition driving the market.
• The argument for voluntary cooperation, for a free market, is not nearly so simple. It says, “You know, if you allow people to cooperate voluntarily and don’t interfere with them, indirectly, through the operation of the market, they will improve matters more than you can improve it directly by appointing somebody.

Suppose I need a loan.  If it’s a local business, a community bank might have more insight.  Certainly more insight than a Washington bureaucrat.  Shouldn’t we allow the bank to determine what relationship it has with its own customers.  The bank can only lend off the assets it owns.  It has an incentive to stay in business.  Community banks aren’t going actively try to make bad loans.

Today, if you want to do a small loan for a small business you are likely to get turned down at one of the major banks.  The reason is the cost to process a loan for them is the same no matter what size of loan they process.  They have an incentive to do huge loans.

The solution isn’t just to pull off a bunch of government regulation without making other changes.  I think that Professor John Cochrane has done a good job talking about how to reign in banks from causing disruptions to the market like we had in 2008.   If you put his reforms in place, you could pull a lot of the regulations off the books and I think it would give community banks breathing room to compete.

That would be great for America.  I think that more capital would be able to flow to places that might be able to put it to work profitably.  It might be a boon to medium and small towns if those towns found projects that generated cash flow positive that banks would participate in.