Sink-or-swimThough smaller financial institutions had little role in the recent financial crisis, they were struck with heavy regulation to match the large institutions. And because of these burdens, the market share for smaller financial institutions is shrinking at an alarming rate. A report released this last February by the Harvard Kennedy School on “The State and Fate of Community Banking” is capturing industry attention for its dire findings. According to the report’s authors, the community banks’ share of U.S. banking asset and lending markets has fallen by 50% in the last 20 years. Moreover, the rate of decline has increased significantly in the past four years—almost double the rate it had sunk in the previous 16 years of decline.

A Life Raft

First, some good news. The report points out that community banks service a disproportionately large amount of key segments of the U.S commercial bank lending market. These fields are where small banking is thriving:

Agricultural Loans

According to report, community banks made up 77% of the United States’ agricultural loans in mid-2014. The volume of these types of loans has increased by nearly 20% since mid-2010. Even though agricultural loans are not a huge part of the lending market, these numbers are encouraging.

Real Estate Lending

Overall, community banks also make up a disproportionately large share – 46% – of the commercial real estate lending market. These loans (some of which are small business loans) made up 14 percent of the market and were worth $1.1 trillion in 2014.

Small Business Loans

The report reveals a surprising statistic—community banks provided about half of all small business loans from 2000–2014. However, despite this strong presence in the small business lending market, the overall volume of small business lending from community banks has gone down 11% since mid-2010.

In the Eye of the Storm

What are the biggest challenges for small financial institutions?

High Tide

So the news is not all bleak. But the report does spell out what many smaller financial institutions already know. Whereas the community banks’ share of the assets and lending markets was 40 percent in 1994, that number has gone down to 20 percent last year. And in the first four years since Dodd-Frank passed, the rate of decline almost doubled the rate of the prior four years.
Though small institutions are vital to the market by bringing a different set of strengths to the table, they are still losing market share and volume in individual, small business, and residential mortgage lending markets.
Not surprisingly, the report spends quite a bit of time on the disproportionate cost of regulations on small institutions.
Here are some of the findings cited by researchers in this report:

  1. Due to the threat of higher regulation, more than one quarter of small banks planned to hire new compliance or legal personnel in the next 12 months, and another quarter were thinking about it.
  1. More than one-third of banks had already hired new staff in order to meet new CFPB regulations. To put these numbers in perspective, hiring two additional personnel reduces median profitability by 45 basis points, resulting in one-third of those banks becoming unprofitable. It was noted by Fed Governor Tarullo that, “Any regulatory requirement is likely to be disproportionately costly for community banks, since the fixed costs associated with compliance must be spread over a smaller base of assets.”
  1. The cost of industry compliance is pegged at $50 billion annually, or 12% of operating costs. The Chairman of the community bankers Council of the American Bankers Association, William Grant said that for community banks “the cost of regulatory compliance as a share of operation expenses is two0and0a-half times greater for small banks than for large banks.”
  1. The cost of regulatory compliance as a share of operating expenses is two-and-a-half times greater for smaller banks than larger banks.

Fierce Waves

According to the report, there are six compliance concerns that are most burdensome to the smaller financial institution:

  1. Truth in Lending Act and Regulation Z rules governing open-end and closed-end changes stemming from the Dodd-Frank Act and the Credit CARD Act
  2. Real Estate Settlement Procedures Act changes from Dodd-Frank that govern modifications to residential mortgages
  3. Bank Secrecy Act and anti-money laundering rulemakings surrounding customer identification and due diligence
  4. Fair Credit Reporting Act rules that require the establishment of the Identity Theft Red Flags Program and the development of risk-based pricing notices
  5. Capital planning and stress testing regulations required by the Dodd-Frank Act

Because of these concerns, a recent Harvard Business School working paper reported that regulatory burdens may be impeding community banks’ ability to participate in small business lending markets. In the late 2014 ICBA survey, 26 percent listed “regulatory burden” as a factor-hindering consumer lending.
In addition, it seems that regulation – as opposed to market forces – appears to be an increasingly powerful force driving the growth of bank mergers.

Keep Your Head Above Water

Because of these troubling findings, the report adds its voice to those calling for regulatory relief. Three suggestions are made for policymakers to mitigate these trends and avert negative consequences in U.S. lending markets?

  1. Reform the regulatory process to mitigate unintended consequences—To ensure better-designed regulation in the future and avert unintended consequences that jeopardize lending market vitality in the U.S., more robust economic analyses of financial regulatory rule-makings are needed.
  2. Improve existing regulations—A bipartisan commission should be established to identify opportunities to merge, streamline, and simplify banking and consumer financial regulations, particularly with regard to the effects they have on community banks.
  3. Expand community banks’ regulatory exemptions—Complex risk-weighted capital requirements may be appropriate for large financial institutions, but they are not for community banks.

Just Keep Swimming

What can your small institution do to stay competitive?

Personal Relationships

The report reaffirmed that small financial institutions create strong, mutually beneficial bonds with with individuals and small businesses. This gives community banks a critical and unique role in the U.S. economy. According to the Consumer Financial Protection Bureau (CFPB), community banks “can be a lifeline to hardworking families paying for education, unexpected medical bills, and homes.” According to the report, community banks distinguish themselves by relying heavily on personal relationships. Small financial institutions have the “ability to gather and consider ‘soft information’ that enables them to lend to borrowers they may be snubbed by larger institutions.


Failure to embrace technology is noted as a large hinderance to to community banks. But this can also be viewed as an opportunity. Through technology, smaller institutions are able to reach out to new markets and offer new services, they are able to open better communication which strengthens personal relationships.
Tapping into technology to help manage those increasing regulatory burdens is one way that smaller institutions can compete. And is specifically what the AffirmX Risk Intel Center platform is designed to do—help financial institutions more cost-effectively manage their compliance burdens. To learn more, check out this video, explaining how the AffirmX platform can help.
So, yes, the situation facing smaller financial institutions is challenging, but to those who can manage to adapt while keeping those strengths that make them vital to their communities, it is clear that there remains a need that large institutions can’t meet.