shrinking banking industry

The Dearth of De Novos

Economists Roisin McCord and Edward Simpson Prescott have taken an in-depth look at the rapidly shrinking banking industry (in terms of the number of banks) in the United States since the Great recession of 2007-08 and come to the conclusion that the cause is the unprecedented decline in the creation of new banks since 2010.

From the “Economic Brief” (co-authored with Tim Sablik) that summarizes the more detailed analysis linked above):

The financial crisis of 2007–08 significantly altered the banking landscape. From 2007 through 2013, the number of commercial banks in the United States fell by more than 800, a 14 percent decline. This drop was highly concentrated among small community banks (banks with less than $50 million in assets), which saw their numbers shrink by 41 percent.Although many banks failed during the crisis and its after-math, this decline was driven largely by a lack of new banks. The number of newly formed banks (called de novo banks) has fallen sharply since 2010. In 2012, there were no de novos”, and in 2013 there was only one: Bank of Bird-in-Hand,formed in Lancaster County, Pa., to serve the Amish community.

The authors claim that this “collapse in new bank entry” is unprecedented “and could have significant economic repercussions.”

In particular, the decline in new bank entry disproportionately decreases the number of community banks because most new banks start small. Since small banks have a comparative advantage in lending to small businesses, their declining number could affect the allocation of credit to different sectors in the economy.

The authors take a look at other financial crises in this country during the past 50 years. While the erosion of interstate branching barriers and the financial impact of previous banking crises had reduced the number of independent commercial banks from between 12,000 and 13,000 in 1980 to less than 7,000 in 2000, each previous economic recession that caused an accelerated reduction in the number of banks through bank failures and mergers was accompanied by the robust creation of new banks to offset the failures. The last five years do not differ markedly from the exit rate of banks in previous years. What is remarkably different about the last five years is the almost complete absence of new bank creation. From 2011 through 2013, only four new banks were created.

The authors discuss the possible reasons for the lack of de novo creation. One explanation is low bank profitability as the result of the Fed’s low-interest-rate policies and the resultant anemic net interest margins. However, in discussing another Federal Reserve Board study that takes this position, the Richmond Fed’s economists contend that a “literal interpretation of ” the FRB’s model “would predict that even if the net interest margin and economic conditions recovered to 2006 levels, there still would be almost no new bank entry.” They also cite another study, this one by the Federal Reserve Bank of Kansas City, that concludes that while the net interest margin is historically low, it is similar to the net interest margin that followed the 2001 recessions and higher than the net interest margin during the recovery from the 1981-82 recession.

Another potential factor discussed is the high cost of operating a small bank due to the plethora of regulations enacted in the wake of the Great Recession, including those mandated by the Dodd-Frank Act. While the authors note that a recent study found that compliance staffs and costs have risen substantially since 2010, the ratio of non-interest expenses to assets for community banks has not increased significantly. Therefore, regulatory costs, standing alone, may not be a major deterrent to de novo creation, since they may be offset by decreases in other costs.

Another factor, which we also have discussed, involves the time and expense of de novo applications, especially the applications process for insurance of accounts filed with the FDIC. The process is long and expensive, and there has been a much greater chance than in previous economic cycles that the FDIC will not grant approval. Spending considerable time, money, and brain cells, not to mention the cost of cases of anti-acids to fight the heartburn, with a questionable chance of approval has, in our experience, been a major deterrent.

Once potential deterrent, the 2009 policy of the FDIC to extend the period of time that new banks are subject to greater examination costs and higher capital requirements, was allegedly abandoned by the FDIC within the past year. We think that the jury is still out as to whether this abandonment is real or window dressing.

Obviously, the authors of this study, working within the bank regulatory system, are required to be more circumspect and less opinionated. As one living outside that system and being possessed of a faulty governor of my internal sense of circumspection, I can be blunter. My personal concern is that I have neither heard nor read anything recently that convinces me that the same regulators at the FDIC who made comments a few years ago that there were too many banks in the United States, and they were in the business of reducing, not maintaining, the total number of banks, have changed their opinion.

Whatever the reasons for the dearth of de novos, the study’s authors draw some stark conclusions.

The current decline in commercial banks appears to be driven largely by the complete collapse of new bank entry. If entry remains weak and the exit rate remains constant, the number of banks overall, as well as the number of community banks, will continue to fall.

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