[Senate Hearing 112-77]
[From the U.S. Government Publishing Office]
S. Hrg. 112-77
THE STATE OF COMMUNITY BANKING: OPPORTUNITIES AND CHALLENGES
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HEARING
before the
SUBCOMMITTEE ON
FINANCIAL INSTITUTIONS AND CONSUMER PROTECTION
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
FIRST SESSION
ON
EXAMINING THE CURRENT ECONOMIC AND REGULATORY ENVIRONMENT FACING
COMMUNITY BANKS
__________
APRIL 6, 2011
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.fdsys.gov /
____
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68-056 PDF WASHINGTON : 2011
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia MARK KIRK, Illinois
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
Dwight Fettig, Staff Director
William D. Duhnke, Republican Staff Director
Dawn Ratliff, Chief Clerk
Brett Hewitt, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Financial Institutions and Consumer Protection
SHERROD BROWN, Ohio, Chairman
BOB CORKER, Tennessee, Ranking Republican Member
JACK REED, Rhode Island JERRY MORAN, Kansas
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey MIKE JOHANNS, Nebraska
DANIEL K. AKAKA, Hawaii PATRICK J. TOOMEY, Pennsylvania
JON TESTER, Montana JIM DeMINT, South Carolina
HERB KOHL, Wisconsin DAVID VITTER, Louisiana
JEFF MERKLEY, Oregon
KAY HAGAN, North Carolina
Graham Steele, Subcommittee Staff Director
Michael Bright, Republican Subcommittee Staff Director
(ii)
C O N T E N T S
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WEDNESDAY, APRIL 6, 2011
Page
Opening statement of Chairman Brown.............................. 1
Opening statements, comments, or prepared statements of:
Senator Corker............................................... 3
Senator Tester............................................... 3
Senator Vitter............................................... 4
Senator Hagan................................................ 4
WITNESSES
Maryann F. Hunter, Deputy Director, Division of Banking
Supervision and Regulation, Board of Governors of the Federal
Reserve System................................................. 5
Prepared statement........................................... 27
Sandra L. Thompson, Director of Risk Management Supervision,
Federal Deposit Insurance Corporation.......................... 6
Prepared statement........................................... 30
Jennifer Kelly, Senior Deputy Comptroller for Midsize and
Community Bank Supervision, Office of the Comptroller of the
Currency....................................................... 7
Prepared statement........................................... 36
John P. Ducrest, Commissioner, Louisiana Office of Financial
Institutions, and Chairman, Conference of State Bank
Supervisors.................................................... 8
Prepared statement........................................... 42
William A. Loving, President and Chief Executive Officer,
Pendleton Community Bank, Franklin, West Virginia, on behalf of
the Independent Community Bankers of America................... 18
Prepared statement........................................... 52
Tommy G. Whittaker, President and Chief Executive Officer, The
Farmers Bank, Portland, Tennessee, on behalf of the American
Bankers Association............................................ 20
Prepared statement........................................... 56
Paul Reed, President, The Farmers Bank and Savings Company,
Pomeroy, Ohio, on behalf of the Ohio Bankers League............ 21
Prepared statement........................................... 65
Additional Material Supplied for the Record
Letter submitted by Chairman Sherrod Brown....................... 71
Letter submitted by Sandra L. Thompson, Director of Risk
Management Supervision, Federal Deposit Insurance Corporation.. 73
Letter submitted by Jennifer Kelly, Senior Deputy Comptroller for
Midsize and Community Bank Supervision, Office of the
Comptroller of the Currency.................................... 77
Prepared statement submitted by the Retail Industry Leaders
Association.................................................... 82
(iii)
THE STATE OF COMMUNITY BANKING: OPPORTUNITIES AND CHALLENGES
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WEDNESDAY, APRIL 6, 2011
U.S. Senate,
Subcommittee on Financial Institutions and Consumer
Protection,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 3 p.m., in room SD-538, Dirksen
Senate Office Building, Hon. Sherrod Brown, Chairman of the
Subcommittee, presiding.
OPENING STATEMENT OF CHAIRMAN SHERROD BROWN
Chairman Brown. The Subcommittee on Financial Institutions
and Consumer Protection will come to order.
This is our first hearing under my chairmanship of the
Subcommittee. I look forward to working with Ranking Member
Corker, whom I have enjoyed working with. We came to the Senate
at the same time, got on the Banking Committee at the same
time, and he has been a valuable Member on all kinds of
bipartisan efforts in a Committee that has had over the years
pretty good bipartisan cooperation. I appreciate Senator Tester
being here, who also joined us at the same time.
This hearing will be a bit truncated in this sense, that at
4, we have seven votes and we are going to have to adjourn
then, so we probably will not ask the Government witnesses our
questions. It probably will not be as extensive for them
orally, but some of us, I assume, will have written questions
for them. So we will begin the hearing.
This hearing is important for a lot of reasons today. It is
an especially timely hearing since April is Community Banking
Month. A lot has changed in the banking industry in the last 2
years, putting it mildly, including new consumer protections,
including credit card reforms and a Consumer Financial
Protection Bureau, enhanced regulatory scrutiny and
supervision, challenges relating to capital reserves and
funding sources, and, of course, new proposed reforms for the
interchange fee structure, something we have all heard a lot
about, mostly thanks to Senator Corker and Senator Tester, so
thank you for that. There has been a lot of disagreement about
these proposals, both among Members of the Committee and among
bankers.
One thing that bankers and regulators and consumer
advocates could all agree on is the importance of community
banks. Community banks have what Ohio Bankers League President
Mike Van Buskirk, who has joined us today, has called high-
touch responsiveness to the local area. Fed Chairman Bernanke
has said that community bankers live and work where they do
business. Their institutions have deep roots, sometimes
established over several generations. Elizabeth Warren has said
that community banks work hard to be trusted long-term partners
with the families they serve. Banks with close relationships
with their customers are better able to safely make loans to
startups or expanding small businesses.
I have done some 150 roundtables around Ohio in virtually
every community in the State, and often, a community banker is
part of these roundtables of 15 to 20 people, and their
involvement and reach into the community is always exceptional.
Banks with close relationships with their customers are better
able, as we all know, to safely make loans to startups or
expanding small businesses. Mr. Van Buskirk, as he pointed out,
while Wall Street banks' computer algorithm might tell a banker
to reject a loan, a local banker's personal expertise might
tell the same banker to approve that loan.
Community banks do not trade in complex and opaque
financial products. They do not speculate in markets that have
been created to simply turn money into more money. Yet despite
the importance of our Nation's community banks, because of a
slumping housing market and declining economy, we lost 157
community banks last year, the most since 1992, when our
economy was in a recession following the savings and loan
crisis. In my State, community bankers have weathered the
financial storm better than most. We lost only two, but two,
nonetheless, community banks in Ohio in 2010.
So we are here today to discuss what we need to do for
community banks so they can invest more in small businesses and
consumers.
As Cam Fine, the President of the Independent Community
Bankers, has acknowledged, Dodd-Frank does create an important
precedent that recognizes two distinct sectors within the
financial services spectrum, Main Street community banks and
Wall Street megabanks. Dodd-Frank was crafted to address those
institutions that are too big and interconnected to fail. The
Volcker Rule provision bans federally insured banks from
trading for their own profit. The new Financial Stability
Oversight Council will oversee large banks and systematically
important financial companies. Enhanced capital requirements
will apply to financial companies that are systematically
important, and there will be greater oversight in transparency
of the derivatives market.
Recognizing the importance of our community institutions,
there are a number of targeted benefits for community banks in
Dodd-Frank. Those under $10 billion of assets will not be
examined by the Consumer Financial Protection Bureau. They have
been exempted from parts of Sarbanes-Oxley. Certain small banks
are exempt from new regulatory capital and leverage rules.
Despite these efforts to help community banks maintain
their competitiveness, challenges remain. One of the greatest
threats to community banking is unfair competition and industry
consolidation, with banking now more concentrated, excessively
more concentrated than it was before the crisis. In 2006, the
top ten banks made up 68 percent of total assets. At the end of
2010, they held 77 percent of total banking assets, and there
still may be more consolidation ahead. A recent survey of
corporate merger and acquisitions advisors ranked financial
services in a tie for second among industries most likely for
consolidation.
Megabanks have greater options for raising capital in the
debt and equity markets and they enjoy a lower cost of funds.
In the fourth quarter of last year, a $100 billion bank enjoyed
an 81 basis point advantage over its $10 billion competitor.
The ICBA has argued for imposing severe restrictions on any
further growth and consolidation within the industry. I agree
that we need to working to ensure that banks are more regional
and more responsive to local communities.
Community banking is especially very important in the
Midwest. Our community banks are our small business lenders.
They must play a central role in strengthening the business
community in America's recovery. Congress and community banks
are both here to support the job creator who just needs a
little help from the corner bank to turn his dream or her dream
into a profitable venture. We should work together to achieve
that goal.
Senator Corker.
STATEMENT OF SENATOR BOB CORKER
Senator Corker. Mr. Chairman, thank you. I know we have
this panel and another one where folks have traveled from
around the country, so I thank you for having this hearing.
I think all of us have seen historically, when there is
massive regulation, the big get bigger and the smaller
institutions with lesser staff to deal with these regulations
end up bearing the brunt of that. So I thank you for having
this hearing and I am not going to say anything else. I would
rather hear our witnesses and move on, especially to the second
panel. I know many of you all are here in Washington and we
have great access to you, but we thank you all for being here
and look forward to your testimony.
Chairman Brown. Senator Tester.
STATEMENT OF SENATOR JON TESTER
Senator Tester. Yes, thank you, Mr. Chairman.
I just want to say, as we come out of the worst economic
mess since the 1930s and what was a potential total financial
meltdown, I think the regulatory environment as it applies to
community banks is critically important. We are hearing--I am
hearing issues that revolve around consistency and
predictability as it applies to our regulators that regulate
our community banks and it is very concerning to me because
there has to be predictability in the regulation as it goes
forward. Otherwise, the community banks are continually bounced
around on that. Why is this important? Because community banks
loan to small businesses. Small businesses create the majority
of jobs in this country.
And so I want to thank all the panelists for being here
today and look forward to your testimony and the questions we
will have for you, and maybe your questions for us, too, as we
go on with this hearing. So thank you very much.
Chairman Brown. Senator Vitter, you wanted to introduce Mr.
Ducrest, I understand.
STATEMENT OF SENATOR DAVID VITTER
Senator Vitter. Yes, thank you, Mr. Chairman.
I just wanted to make two quick points. First of all, I
want to welcome and introduce one of our panelists, John
Ducrest. He is a Louisiana native of Broussard, Louisiana, and
is our Commissioner of the Office of Financial Institutions,
and he has served in that very important post, which is
basically the top bank regulator in the State, since June 8,
2004. He has a solid record and list of experience leading up
to that job. He basically had been in that very important
office for nearly 26 years, filling multiple roles in that
office in the State, and particularly distinguished himself
during Hurricane Katrina for his tireless leadership in working
with other State officials and the Federal Government to ensure
a smoothly functioning system. So, John, thank you for your
work. Thank you for your upcoming testimony.
I also just want to express disappointment that we do not
have as a witness at this hearing anyone from CFPB, Elizabeth
Warren, or anyone else. I think, clearly, that new super-
bureaucracy is going to have a huge impact, and in my view is
going to be a huge threat to the continued viability of
community banks.
The Chairman correctly noticed the exemption in terms of
outright monitoring of community banks, but still CFPB will
have enormous power over products that community banks have to
deal with and compete with, and so it is going to be an
enormous influence on the new environment that community banks
have to try to survive in, and I am very, very concerned about
that new threat to community banks created by Dodd-Frank.
Thank you, Mr. Chairman.
Chairman Brown. Thank you, Senator Vitter.
The agency/bureau is still an inchoate organization in some
sense and they do not have enforcement authority, is the reason
they are not here today. But we will certainly have hearings
where they will be included and you will be brought in on those
discussions.
Senator Hagan.
STATEMENT OF SENATOR KAY HAGAN
Senator Hagan. Thank you, Mr. Chairman, and as a new Member
of the Subcommittee, I am very pleased to be on it.
I do think that community banks are crucial to the success
of this economic recovery. I know that in North Carolina, we
have community banks and independent banks all over our State
and they are definitely in contact with me on many occasions,
talking about the impact of this recession and how the
regulatory aspects and, in many cases, the inability to make
loans that they have in the past has been an impact to them.
But the community banks play a significant role in my State and
other States around the Nation and we know how important you
are. Thank you.
Chairman Brown. Thank you, Senator Hagan.
Let me just introduce the four witnesses. Maryann Hunter is
Deputy Director of the Division of Banking Supervision and
Regulation, Board of Governors of the Federal Reserve. Welcome,
Ms. Hunter.
Sandra Thompson is Director of the Division of Risk
Management Supervision at the FDIC. Welcome, Ms. Thompson.
Thank you for joining us.
Jennifer Kelly is Senior Deputy Comptroller for Midsize and
Community Bank Supervision, Office of the Comptroller of the
Currency. Thank you for joining us, Ms. Kelly.
And Mr. Ducrest, who was introduced by Senator Vitter, is
Louisiana Commissioner of Financial Institutions and Chairman
of the Conference of State Bank Supervisors.
Begin your comments, if you would, Ms. Hunter.
STATEMENT OF MARYANN F. HUNTER, DEPUTY DIRECTOR, DIVISION OF
BANKING SUPERVISION AND REGULATION, BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Ms. Hunter. Thank you. Chairman Brown, Ranking Member
Corker, and Members of the Subcommittee, thank you for the
opportunity to testify today on the challenges and
opportunities facing community banks. The vast majority of the
roughly 830 banks and 4,700 of the bank holding companies under
Federal Reserve supervision are community institutions and we
understand their importance to the broader economy.
I began my career as an examiner in the Kansas City
District of the Federal Reserve and have seen firsthand the
important connection between community banks and their
communities. The economic downturn has had a significant impact
on community banks, and unfortunately, many continue to
struggle. Significant improvement in financial condition will
likely take considerable time, as well as continued improvement
in real estate markets for many smaller institutions. There are
some positive signs, however, as nonperforming assets continue
to fall and many healthy community banks have continued to lend
to creditworthy borrowers.
The Federal Reserve has recently undertaken two initiatives
to formalize and expand our ability to understand the
perspectives of community banks and the challenges they face.
The Board recently established a special supervision
subcommittee of Board members to provide a special focus on
community bank issues. And it also has formed a Community
Depository Institutions Advisory Council, or CDIAC, as we call
it, with representatives from councils in all 12 districts. The
CDIAC and related councils provide the Board and system with
direct insight and information from community bankers about the
economy, lending conditions, supervisory matters, and other
concerns.
Through our contacts with community bankers, we
consistently hear that the changing regulatory environment,
including the Dodd-Frank Act, present challenges and concerns
for community banks. Recent reforms are directed principally at
the largest and most complex U.S. financial firms and
explicitly exempt small banks from the most stringent
requirements. However, community bankers remain concerned that
the expectations being set for the largest institutions will
ultimately be imposed in a burdensome manner on smaller
institutions and that compliance costs may fall
disproportionately on smaller banks that lack economies of
scale, which then could lead to further consolidation in the
banking sector.
As we at the Federal Reserve develop rules and policies to
implement new statutory requirements, we will use the feedback
from the CDIAC, public comments on proposed rules, and
information from ongoing interactions with community banks and
our State Bank Commissioners to address specific issues of
concern to them.
In closing, I would like to emphasize that the Federal
Reserve will continue to listen to the concerns of community
banks and carefully weigh the impact of regulatory and policy
changes on them while at the same time we work with them to
address these future challenges.
I thank you for inviting me to appear before you today on
this important subject and I would be pleased to answer any
questions that you may have.
Chairman Brown. Thank you, Ms. Hunter.
Ms. Thompson.
STATEMENT OF SANDRA L. THOMPSON, DIRECTOR OF RISK MANAGEMENT
SUPERVISION, FEDERAL DEPOSIT INSURANCE CORPORATION
Ms. Thompson. Chairman Brown, Ranking Member Corker, and
Members of the Subcommittee, I appreciate the opportunity to
testify on behalf of the FDIC regarding the state of community
banking.
Community banks provide vital services around the country.
These banks make loans to customers they know in markets they
know. They play a critical role in providing credit to local
businesses. In fact, during the recent crisis, community banks
continued to lend, whereas lending declined in larger
institutions.
As the supervisor of approximately 4,400 community banks,
the FDIC has a keen appreciation for the important role these
banks play in the national economy. Our bank examiners work out
of duty stations in 85 locations around the country. They know
the banks in their areas and are familiar with local economic
conditions. Many of our examiners have seen banks work their
way out of more than one economic downcycle. Therefore, they
understand firsthand the critical role that community banks
play in credit availability.
We experienced a high number of bank failures in 2009 and
2010, and a number of community banks still face headwinds in
the form of legacy loan problems in their real estate
portfolios. But we believe that last year marked the peak for
bank failures and 2010 shows signs of a turnaround starting for
community banks. Earnings at many community banks improved last
year, in direct contrast to the widespread net losses that were
reported in 2009. Asset quality deterioration appears to have
leveled off, but volumes of troubled assets and charge-offs
remained high. Community banks continue to have high
concentrations of commercial real estate loans, a market
segment that remains weak in many areas of the country. Bankers
are continuing to work through these problems.
Through the economic downturn, the FDIC has advocated for
policies that help community banks. We have been a part of all
interagency efforts that encourage banks to originate and
restructure loans to creditworthy borrowers.
One of the concerns that community banks frequently raise
is the implementation of the Dodd-Frank Act and how it will
affect their operations. We understand this. I would point out
that much of the Act does not affect the operations of
community banks and certain of the law's changes provide real
benefits for them.
For example, the deposit insurance coverage limit was
permanently increased to $250,000. All balances in non-
interest-bearing transaction accounts above $250,000 will be
insured until the end of 2012. In addition, premium assessments
were shifted so that more of the costs will be borne by large
institutions. As a result, community banks will see their
assessments decline by 30 percent. These changes should help
community banks by giving them access to federally insured
funding in larger amounts. Further, many provisions of the
Dodd-Frank Act should restore market discipline by ending too-
big-to-fail and ensuring appropriate regulatory oversight of
the largest financial companies and nonbank competitors.
Nevertheless, we understand that community banks are wary
about new regulatory requirements and regulatory burden and we
are taking steps to address their concerns. As described in my
written statement, the FDIC has undertaken several initiatives
to eliminate unnecessary regulatory burden on community banks.
In summary, we believe that community banks are an
essential part of the financial system. We are committed to a
regulatory structure that will support a vibrant, competitive
community banking sector and a level playing field between
large and small banks.
Thank you for the opportunity to testify and I will be
happy to answer questions.
Chairman Brown. Thank you, Ms. Thompson.
Ms. Kelly.
STATEMENT OF JENNIFER KELLY, SENIOR DEPUTY COMPTROLLER FOR
MIDSIZE AND COMMUNITY BANK SUPERVISION, OFFICE OF THE
COMPTROLLER OF THE CURRENCY
Ms. Kelly. Thank you. Chairman Brown, Ranking Member
Corker, and Members of the Subcommittee, thank you for this
opportunity to talk about the condition of community banking in
the United States and the potential impact of the Dodd-Frank
Act on those banks.
As the Senior Deputy Comptroller for Midsize and Community
Bank Supervision, I am the senior OCC official responsible for
the supervision of nationally chartered community banks. The
OCC supervises 1,200 banks with less than $1 billion in assets.
The majority of our resources, including 75 percent of our
examination staff, are devoted to community bank supervision.
In July, when the supervision of Federal Savings
Associations is transferred to the OCC, over 650 more
institutions will come under OCC supervision. Almost all of
those are community institutions.
Community banks play a crucial role in providing consumers
and small businesses in communities across the Nation with
essential financial services and credit that is critical to
economic growth and job creation. While the recent economic
cycle has been difficult and extremely challenging for
institutions of all sizes, I am pleased to report that
conditions are beginning to stabilize for community banks and
we are seeing these institutions return to profitability.
And despite the financial crisis and the deep recession,
three-quarters of the community banks we supervise have
satisfactory supervisory ratings, reflecting their sound
management and strong financial condition. These banks have
successfully weathered the recent economic turmoil by focusing
on strong underwriting practices, prudent limits on loan
concentrations, and stable funding bases.
However, the operating environment for community banks
remains challenging. Lending activity, which is the primary
revenue source for community banks, has been hampered by the
overall economic downturn and net interest margins are at
historic lows. At the same time, community bank financial
performance continues to be pressured by the elevated levels of
problem loans, particularly in the area of commercial real
estate.
Against this backdrop, it is easy to understand why
community banks are apprehensive about how the Dodd-Frank Act
will affect their business. Although much of the Act was
intended to apply exclusively to large banks, smaller
institutions will feel the impact in a number of ways. As
discussed at greater length in my written statement, they will
be subject to new regulations that impose additional
restrictions and compliance costs as well as limits on revenues
for certain products.
We at the OCC are mindful of the economic challenges and
regulatory burdens facing community banks, and we recognize
that a new law as comprehensive and complex as the Dodd-Frank
Act may magnify these challenges. Our goal is to implement the
Dodd-Frank Act in a balanced way that accomplishes the law's
intent without unduly hampering the ability of community banks
to support their local economies and provide the services their
customers need. It will be extremely important that we hear
from community banks during the comment process of our
rulemaking efforts to help determine whether we achieve this
goal and whether additional changes or alternatives could be
considered to lessen the burden on community banks. I can
assure you, we will be listening.
Again, I appreciate the opportunity to appear before the
Subcommittee today and look forward to your questions.
Chairman Brown. Thank you, Ms. Kelly.
Mr. Ducrest.
STATEMENT OF JOHN P. DUCREST, COMMISSIONER, LOUISIANA OFFICE OF
FINANCIAL INSTITUTIONS, AND CHAIRMAN, CONFERENCE OF STATE BANK
SUPERVISORS
Mr. Ducrest. Thank you, Mr. Chairman. Thank you, Senator
Vitter, for the kind introduction. I think I probably could
skip my whole opening remarks just echoing your comments and
Senator Corker's comments in your opening statement, but I
think my staff's heart would skip a beat if I did that, so I
will follow my prepared statement.
Good afternoon, Chairman Brown, Ranking Member Corker, and
distinguished Members of the Committee. My name is John
Ducrest. I am Commission of Financial Institutions for the
State of Louisiana and currently serve as our Chairman of CSBS.
Our members regulate approximately 5,600 of the Nation's banks,
the vast majority of which are community banks. Thank you for
holding the hearing today on the area that is a passion for me
and all the commissioners around the country.
As Senator Vitter said, I started my career about 26 years
ago as a field examiner. I saw firsthand the impact that
locally owned small banks have on small-town America. I also
saw, following the many bank closures we had in Louisiana in
the 1980s and 1990s, the changes that happened when locally
owned, locally run banks become branches of large institutions,
when lending decisions, particularly those involving small
businesses, once made locally started being made by out-of-town
institutions or out-of-State institutions.
Community banks are uniquely qualified to be small business
lending experts. The lack of consistent financial data can make
it difficult to quantify or standardize loan decisions.
Community banks engage in relationship banking involving the
use of local knowledge which is not always readily available or
quantifiable. It makes a difference to a small town that these
loans, in addition to the loans that are easier to make, get
made. The impact of local institutions can be particularly
powerful during times of crisis.
Louisiana experienced firsthand the role of community
banks, that they play in providing economic stability during
times of crisis. I witnessed firsthand the need for and the
benefits of local ownership in the aftermath of Hurricanes
Katrina and Rita. In the days immediately following the storms,
I saw the passion that the community bank leadership had to
assist their customers and employees in coping with and
adapting to the new realities. These bankers quickly understood
the displacement of their customers, the customers' need to
access funds, and for people to just see their bankers, the
peace of mind that comes with seeing a familiar face in a
crisis. We approved emergency requests to open branches in
areas where the populations had been relocated so that
customers could go to their bank. Equally important was the
reopening of branches in the impacted areas. Opening at these
locations was critical. Citizens were coming home, checking on
their property, and operating in a cash society. It is
important to realize, as did our community banks, that
following any type of disaster like this, that you are
operating in a cash society.
Over the past several months, we have heard very loudly the
concerns of the community bankers regarding their future. The
level of concern and anxiety that I see today is equal to if
not greater than what I saw in the 1980s when we were closing
banks in Louisiana every Friday. These concerns relate to the
feared effect of Dodd-Frank and other regulatory actions. The
unknown impact of the Durbin Amendment on community banks is
one specific example that has become a lightning rod for
concerns by regulators and industry alike. All of this comes at
a time when community banks continue to see earnings struggle,
face challenges raising capital, and all the while looking to
an uncertain future as the structure and future of larger
institutions in the economy is evolving.
The viability of the community bank model has systemic
consequences which, if left unaddressed, threaten local
economies and erode critical underpinnings of the broader
economy. A diverse financial system characterized by strong
community banks ensures local economic development and job
creation, provides necessary capital for small businesses, and
provides stability and continued access to credit during times
of crisis.
It is critical that policy makers in Washington fully
understand the impact their policies and rules have on smaller
banks in the communities they serve. Put simply, how community
banks are impacted by Dodd-Frank and other regulatory measures
is too important not to understand.
To that end, I offer the following suggestions. First,
there must be continued coordination and consultation between
the Federal and State regulators.
Second, more analysis is needed to fully understand and
appreciate the valuable relationship between community banks
and small businesses. The lack of data analysis in this area
has made it difficult to understand the true importance of a
viable and competitive community banking system. The Fed's
recent formation of the committee that Maryann referred to and
the FDIC's efforts by Sheila Bair are a step in the right
direction.
Finally, Congress and the regulators should investigate
ways to tailor regulatory requirements to institutions based
upon their size, complexity, geographical location, management
structure, and lines of business. The current one-size-fits-all
approach to regulation both in terms of safety and soundness in
compliance and supervision has fallen harder on community
banks.
Thank you again for inviting me to testify. I look forward
to your questions.
Chairman Brown. Thank you, Mr. Ducrest.
I have one question only. I would encourage--well,
certainly any Senator can take up to 5 minutes because we have
seven votes at 4 and we want to get to the three community
bankers. I urge my colleagues to do what they can to help us
reach that.
My question is for Ms. Thompson, if you could, and I think
we will have questions submitted in writing to probably all of
you. Dodd-Frank recognizes--to Mr. Ducrest's comment about one-
size-fits-all, the Dodd-Frank recognizes that megabanks should
be regulated in a different way from community banks. One key
provision requires enhanced standards for capital and leverage
for the largest banks and financial companies.
Ms. Thompson, what is FDIC's view of requiring the largest
banks to hold more capital, and what benefits will that have or
should that have for community banks, in your view?
Ms. Thompson. We believe that required the larger
institutions to have more capital certainly would be
commensurate with the activities that they undertake. Capital
should be commensurate with the risk. And to the extent that
the Dodd-Frank Act, specifically the Collins amendment,
requires that larger institutions at the holding company level
hold as much capital as is required at the insured depository
institution. We think that is important for consistency, that
the holding company and the insured depository institutions
hold capital that is based on the riskiness of the activities
that those institutions undertake.
Chairman Brown. Thank you.
Senator Corker.
Senator Corker. Thank you, Mr. Chairman. I have one
question also.
I think all of us are concerned about regulations creating
unnecessary consolidation, and there are a lot of things we
could talk about, but I will be very specific because of the
time.
Ms. Hunter, the Chairman of the Fed, Ms. Thompson, the
Chairman of the FDIC, Ms. Kelly, the Acting Comptroller, and
even Mr. Ducrest in his comments--all have expressed strong
concerns about the Durbin amendment. And, you know, typically
we here try to rail against regulatory overreach. In this case,
the regulators are even concerned about what they have been
tasked to do. Certainly the Fed has expressed concerns about
the criteria, the FDIC and the OCC strong concerns about what
it is going to do to the community banks. And I am glad Mr.
Ducrest mentioned that.
Could you be specific here? Because we have numbers of
people that, you know, I think wish they had not voted for it.
I did not. But could you explain what your concerns are as it
relates to community banks and the Durbin amendment?
Ms. Hunter. The issues around this are very complex, and as
you pointed out, we at the Federal Reserve have been studying a
wide range of issues. I will tell you this is not my area of
expertise in terms of the rule that has been drafted related to
this, but there are a range of issues that need to be
understood. We have a proposal that is out for comment. We have
received 11,000 comments, many of which have substantive
concerns in them, and the intent is to fully consider those
comments.
The Chairman has recently sent a letter outlining some of
the concerns underlying the interchange fee issue, and it is
our intent to consider those. He has already been notified that
we will need more time to fully consider those concerns and
consider the impacts on community banks.
Senator Corker. It is one of the first times the Fed has
missed a deadline, and it is because it is so complex, but go
ahead.
Ms. Thompson. Yes, our Chairman, Sheila Bair, sent a letter
to Chairman Bernanke outlining some of the concerns that the
FDIC has about the interchange fee.
First, we want to make sure that the small issuers--there
are large issuers and small issuers, and we want to make sure
that the small issuer exemption is protected, and we are
advocating a two-tier system so that small issuers can take
advantage of not having to adhere to the fee cap that will be
imposed or that has been recommended.
We also have asked that there be more data on smaller
issuers. I think there was a data survey that was done for some
of the larger issuers, but I am not sure what data exists for
some of the smaller issuers of these cards.
And we also asked for some consideration on the fraud
adjustment. When you have a debit card and it is signature
based, there is a lot more fraud that is contained--that takes
place with the signature-based cards as opposed to the PIN-
based cards. And we think that there ought to be provisions
made for the fraud adjustment.
Also, the network exclusivity option--right now most banks
operate with at least two networks, and one of the alternatives
was four networks. And if you have the four, then almost every
single debit card would have to be reissued, and that would
really increase the costs for many of the banks, which would be
very burdensome for the smaller institutions.
But we would be happy to submit the letter that Chairman
Bair sent for the record.
Senator Corker. Thank you.
Ms. Kelly. Speaking on behalf of the Comptroller of the
Currency, we also submitted a fairly detailed comment letter to
the Federal Reserve. It is a very complex issue, and in the
interest of time, I will not go through all the details, but,
again, as Sandra said, we would offer our letter as an outline
of what we see as some of the complicated issues that we are
standing ready to work with the Federal Reserve to try to work
through this.
Mr. Ducrest. Senator Corker, the same thing. Sandra's
comments are exactly what--you know, we sent a letter also to
the Fed commenting on the State Commissioners' perspectives.
Senator Corker. Mr. Chairman, I will stop. I would just say
the two sponsors of the bill oppose the Durbin amendment. All
the regulators have concerns. Community banks have concerns.
And it seems to me that at a minimum to at least look at this
for a period of time--it is very complex; it is going to be
very damaging to community banks--would be a reasonable
approach, even for people who may have supported the
legislation, because of all the concerns that all the
regulators themselves, which is very rare, are bringing forth
to us. And I thank you so much for having the hearing so we
could talk about that.
Chairman Brown. Thank you.
Senator Tester.
Senator Tester. Yes, thank you, Mr. Chairman, and I want to
thank Senator Corker for his questions. I am not going to
repeat them. I think they are spot on. It is too bad everybody
in the Senate cannot hear the concerns that you put forth,
because your bosses put forth the same concerns.
To get to the point that I want to talk about, I want to
talk about regulation. The smaller institutions, as the
gentleman from Louisiana pointed out, are fundamentally
different than larger banks and should be regulated and should
have regulation applied to them in a way that is consistent and
appropriate with that size and risk. And I am very concerned
that many of the regulations included in the Dodd-Frank bill,
particularly those intended to create a level playing field for
community banks, will not be effective until and unless we have
more clarity and consistency with respect to how those
regulations are enforced.
I am going to try to take as little time as possible, so if
you guys would be very concise with your answers, that would be
very good.
Mr. Ducrest, you talked about one size fits all from a
regulatory standpoint. Is that what you see is happening in
Louisiana from the Fed and FDIC standpoint, that there is not a
differentiation being made?
Mr. Ducrest. Well, it is a combination of the safety and
soundness part of the exam and also the compliance part. We are
all for a sound compliance approach, but, you know, some
compliance exams take as long as safety and soundness exams.
Senator Tester. OK. And when the regulations are applied,
are they different for bigger banks than littler banks, or are
they the same?
Mr. Ducrest. The same.
Senator Tester. OK. Ms. Hunter and Ms. Thompson, is that
the intent? Is the intent to regulate very small institutions,
community banks per se, and large institutions the same way? Or
is there a difference based on size and risk when you apply
registration?
Ms. Thompson. There is a difference based on size and risk.
We apply the rules based on the riskiness of the institution
and in particular their activities.
One thing of concern is we want to make sure that when we
implement the Dodd-Frank Act--that when we issue guidance to
the industry describing what the new rules are, there is a
description of how these rules will impact community banks
because, again, many of the new rules do not apply to community
banks.
Senator Tester. How do you ensure that those regulations
are in effect different based on size and risk when the
regulators hit the ground?
Ms. Thompson. We have examination procedures that we give
our examiners, and we work together, all regulators, including
CSBS. We meet once a month on the FFIEC and Task Force on
Supervision, and we talk about different policies and
examination procedures.
Senator Tester. OK. Is there any sort of transparency so
that the banks know that there is some difference? That is OK.
I mean, Ms. Hunter is----
Ms. Hunter. I would echo those comments, and add that it is
really in the application of the procedures. If the bank is not
a complex institution and there are not a lot of activities,
then a lot of the procedures do not apply, and examiners do
calibrate in those situations. I guess the transparency might
be in published manuals, but you really could not detect it
from that.
Senator Tester. And I have talked to Ben Bernanke about
this, too, and you are here, you are a little closer to the
ground--at least I hope you are--than he is. And the real
question is: How do you know the regulators are doing what you
think they are doing on the ground? How do you make that
assessment? Do you have people--I mean, how do you make the
assessment?
Ms. Hunter. That is an excellent question and one we
wrestle with often. I will tell you how we go about it.
First of all, we have a lot of communications with the
offices where the field work is actually conducted. They are
responsible for making sure that the examiners are following
the guidelines, using balanced judgments and calibrating their
judgment about what to do with the risk that is there.
That said, we have a lot of training. We have national
phone calls that give guidance to examiners where they all dial
in to hear from the person who crafted a given rule and learn
what the rule intended to accomplish. And we spend a lot of
time communicating with the field about guidelines and rules.
The committees that I referenced in my oral and written
statements, provide us input; and we follow up immediately. So
when we hear that there is an issue where examiners might be
doing one thing or another, we will go back out to the field
and ask--Is this happening? It is really an ongoing dialog.
Senator Tester. And I understand that, you know, especially
what we have come through, it is kind of not on my watch is
this kind of stuff going to happen. But I can tell you that
unequivocally across the board, every time I meet with the
community bankers, they talk about the inconsistency in
application of regulation. And I believe them. And so the
question is: How can we make this process more transparent so
that we can ensure that, in fact, those regulations are applied
in an evenhanded and fair way? Any ideas?
Ms. Hunter. Yes, well, one of the things we have been doing
is working closely with the CSBS because I think the State
Commissioners are a great source of information if they are
seeing inconsistency and we are hearing from bankers there is
inconsistency, we do follow up.
Trying to get consistency across 50 States and all those
jurisdictions is a constant effort. But it is one that we are
committed to doing.
Senator Tester. I do not want to have the members of the
panel get in a scrap, but I just asked Mr. Ducrest if there was
a difference in the way big banks and small banks were being
regulated--at least that is what I thought the question was--
and he said not really. So the question becomes--and I point
this out because it is a problem, and you guys do not need to
wear it. Everybody needs to wear it. And I think there is more
work that needs to be done to make sure that the regulation
fits the risk, and I do not see community banks as causing the
financial crisis that almost took us under. But by the same
token, I see them supporting small businesses that create jobs,
and I think everybody up here has already said that, and you
have said it, too. And so there needs to be--and it is not
easy, but there needs to be some regulatory consistency.
Chairman Brown. Senator Moran.
Senator Moran. Mr. Chairman, thank you. I am sorry we have
structured the afternoon in the way that we have so little
time. I appreciate the topic of the hearing and believe it to
be a very important one.
I have had the opportunity here in the Banking Committee
and on the Appropriations Committee, including the Financial
Services Subcommittee, to talk to Chairman Bernanke and
Chairman Bair and Secretary Geithner, and there seems to be a
theme among regulators, which is: We take into account, we
understand the importance of community banks. We work hard to
create an environment in which they succeed. And yet every time
I talk to a community banker, there is no evidence that that is
the case. And so I can never figure out what the disconnect is
when the regulators tell me we account for a community bank and
the community bankers have no sense of that being the case.
Yesterday, I think, if I understood Secretary Geithner, he
suggested that it is not the new regulations. It is the
examiners who are applying different standards. And it goes to
perhaps what Senator Tester was talking about, and one of the
answers that someone gave was--I think it was you, Ms. Hunter--
that we try to have uniformity from State line to State line
across the borders. But it is the lack of uniformity from one
examination to the next. No banker can make an intelligent
decision today about whether or not to loan to whom he or she
believes is a creditworthy customer because they were fine in
the last exam but now there is a different standard; and yet we
are told there are no additional regulations.
I understand the value of our time here this afternoon. I
guess my only question would be: Can you tell me the
regulations that are placed upon community banks are no more or
less onerous today than they were 2 years ago, 3 years ago?
When you tell me that you account for community banks, can you
back that up by saying no community banker that is operating a
solid, sound institution would have any more trouble today
complying with regulations today than they did--pick a number--
last year, the year before, 2 years before, 3 years before? And
I just cannot believe that is true based upon the conversations
I have with bankers. And the example I always use is I have had
five or six bankers tell me they no longer--hometown bankers no
longer make a real estate loan, a mortgage on a house in their
hometown, because of the burden of the regulations. Now we have
to fingerprint the officer who takes the application, and they
are just worried that if they make that loan and they make a
mistake, the regulators are going to find it to be a loan that
is written up and it is going to call for more capital.
So my question is: Is it true, based upon what you are
telling me about how you account for community banks, that they
are no more regulated or there is no higher standard of
regulations or regulatory burden today than there was just in
the past?
Ms. Hunter. There are more regulations, and it is more
complex, so they are not imagining that. When we are talking
about taking those factors into account, it is really through
looking at what the examiners do and what they do with the
information that they find.
So, for example, banks have a hard time sometimes figuring
out how to apply a new requirement in their operation. Well, if
an examiner sees a new activity and maybe finds that some
mistakes have been made, they should be helping work with the
bank to point out where it can strengthen its risk management.
One of the things we are seeing with bankers who are
struggling more and more in recent years, is that it is partly
a reflection of the fact that the economic environment is so
much more difficult. And so matters--that were not issues a few
years ago now really are because the risk profile has changed.
That is much of what examiners do, they look to see what the
risk is in the context of the environment that they are working
with.
So from that standpoint, I can see why you are hearing
those comments because there are more regulations and it is a
much tougher environment right now, and examiners are pointing
out risks and highlighting things that need to be addressed in
order to strengthen risk management.
Senator Moran. I would only conclude my comments by saying
that it seems to me that--I can see it by the number of
mergers, the cost of being in business for a community bank has
increased dramatically, and you have to have a larger asset
base, customer base to spread those costs among. And it would
be one thing to me if a bank closed or went out of business
because of market forces or because of bad lending practices.
But to lose so many community bankers because of the increasing
cost of being in the banking business is a mistake for the
communities that they serve.
One of our regional bankers told me in January that for the
first time in their bank's history, community bankers are
calling to see, ``Would you acquire our bank?'' Always in the
past it was they were out looking for a bank to acquire. But
our community bankers are facing this financial burden of
trying to stay in business.
One of my bankers tells me that the regulator said, ``Well,
just hire a couple more people to meet these new guidelines.''
It is, like, I only have eight employees now; to have ten is a
question of whether or not my bank is in business or not. And
so I would love to see something different than what I see. I
see the demise of community banking in rural America.
Mr. Ducrest. Could I just add one quick point?
Chairman Brown. Very briefly.
Mr. Ducrest. To clarify my answer to Senator Tester and
tying it to that, mine was more a comment regarding the
compliance with the regulations and laws of one size fits all.
I agree with what Sandra and Maryann said about the way we
customize regulation to the risk profile, but it is exactly
what you are saying. What I was trying to answer Senator Tester
is about the burden of a very small bank trying to do
compliance on a rule that applies to the largest banks.
Chairman Brown. Senator Hagan.
Senator Hagan. Thank you, Mr. Chairman.
My questions and concerns echo what you have been hearing.
We all come from States, many of us, with large urban centers,
but obviously small rural centers, too, and our community banks
play a huge role in both of those areas. But in particular, I
mean, I hear over and over and over again that the community
banks have an incredible regulatory burden, and they are very
concerned about the examinations and the different aspects of
the bank examiners.
One issue that I think you mentioned, Ms. Hunter, is about
the balanced judgment, and, you know, we talk about a balanced
approach from an examination standpoint. And what we are
concerned about is how this impacts small business lending to
smaller companies. I think, Ms. Kelly, you mentioned the fact
that so many of these institutions have so much commercial real
estate lending that is in their portfolios, and we know that we
have come through a severe economic recession, and a lot of the
valuations have gone down. But in many cases--not in all but in
many cases you have still got, you know, high occupancies and
still cash-flow coming in, but the valuation of the asset has
gone down.
So many of these small businesses cannot get further
extensions on some of their lines, and this is such a burden to
many of these smaller communities. I mean, it is really
affecting the whole economy in those areas.
How do you monitor banks to ensure the appropriate
extensions of new credits and appropriate restructuring of
existing loans under reasonable terms? Any of you, feel free to
jump in and look at that question.
Ms. Thompson. Sure. As you mentioned, we just came through
the worst economic cycle ever, and all of the regulators worked
together to issue guidance specifically to address the issue
that you raised regarding restructuring. We are very adamant
about ensuring that our examiners work with institutions so
that the institutions can work with borrowers to restructure
loans so that they can have a good loan that can be repaid.
We are very concerned about ability to repay. We issued
guidance on commercial real estate loan restructuring, and we
have been really watching to make sure that the examiners are
following up with the banks to make sure that they are
restructuring troubled debt.
Senator Hagan. When you say you make sure and you try to
monitor this, what happens if you find something that is not
consistent?
Ms. Thompson. Well, we go in and conduct the examination,
and to the extent that the banker has an issue, if they bring
it to our attention, we will subject that to review either at
our local field office--again, if they are not happy with the
outcome, it goes to our regional office; and if they are not
happy there, it goes to Washington.
I have also established a----
Senator Hagan. If they are or they are not?
Ms. Thompson. Are not.
Senator Hagan. Are not.
Ms. Thompson. I have also established a dedicated mailbox
to allow bankers to have direct contact with me to the extent
that they have issues with their examination because we are
very interested in how these examinations are taking place.
Senator Hagan. And how many times do you alter?
Ms. Thompson. Excuse me?
Senator Hagan. Do you have a percentage where, if they do
not like the outcome and they take it on appeal, that it
actually is, in fact, changed?
Ms. Thompson. Sometimes it does not even get to appeal.
Sometimes it is a discussion with the examiners, and they come
to a good conclusion.
Senator Hagan. Thank you.
Chairman Brown. Thank you, Senator Hagan. Thanks to all of
you, all four of you.
Let us call the next panel up. Unfortunately, it is going
to be a shorter discussion than we hoped. We very much
appreciate the four witnesses. Let me do the introductions as
they move forward.
Bill Loving is president and CEO of Pendleton Community
Bank. Mr. Loving is vice chair of the Independent Community
Bankers of America and the president and CEO of Pendleton
Community Bank in Franklin, West Virginia, past president of
the Community Bankers of West Virginia.
Paul Reed is president of Farmers Bank and Savings Company,
chief executive officer of Farmers Bank and Savings Company, a
community-owned bank with five branches located in separate
markets, a graduate of Ohio University, the Stonier School of
Banking, the Graduate School of Banking at Louisiana State
University. He is from Pomeroy, Ohio.
Tommy Whittaker, chief executive officer, First Farmers
Bancshares--what is that?
Senator Corker. You want me to----
Chairman Brown. Yes, I am sorry. We will let Senator Corker
introduce Mr. Whittaker. I apologize.
Senator Corker. And I will be equally brief. I will say
that Tommy Whittaker is the epitome of a community banker. He
has been with Farmers Bank for 35 years. He is the CEO. He is
involved in every civic activity you could possibly be involved
in in his hometown. And, again, if you had an encyclopedia and
there was a photo of a community banker, it would be Tommy
Whittaker, the kind of person that all of us want to see
flourish all across this country. And so I am thrilled that he
is here. He is a great friend. He is a great citizen in our
State. And, Mr. Chairman, I thank you for allowing him to
testify, and we welcome him here to Washington.
Chairman Brown. At least in the Tennessee version of the
encyclopedia. In the Ohio version, it might be different.
Mr. Loving, thank you for joining us.
STATEMENT OF WILLIAM A. LOVING, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, PENDLETON COMMUNITY BANK, FRANKLIN, WEST VIRGINIA, ON
BEHALF OF THE INDEPENDENT COMMUNITY BANKERS OF AMERICA
Mr. Loving. Chairman Brown, Ranking Member Corker, and
Members of the Subcommittee, my name is William A. Loving, Jr.,
and I am president and CEO of Pendleton Community Bank, a $250
million asset bank in Franklin, West Virginia. I am pleased to
be here today to represent the nearly 5,000 members of the
Independent Community Bankers of America. ICBA appreciates the
opportunity to testify on this important topic as we are the
only trade association dedicated solely to the community
banking industry.
Community banks will play a very significant role in the
economic recovery. We collectively finance the growth of small
businesses where many citizens work in rural, small-town, and
suburban areas. These are customers and markets not
comprehensively served by large banks. Our business model is
based on long-standing relationships in the communities in
which we live. We make loans often passed over by the large
banks because a community banker's personal knowledge of the
community and the borrower gives him firsthand insight into the
true credit quality of a loan. Localized credit decisions made
one by one by the thousands of community bankers across the
country will restore our economic strength.
When community banks thrive, they create a diverse,
competitive financial services sector with real choice,
including customized products to consumers and small businesses
alike. One of the most harmful consequences of the financial
crisis for community banks is the overreaction among bank
examiners. As we have stated many times to Members of this
Committee, there continues to be a disconnect between the
examiners in the field and the directives from Washington.
Many of my community bank colleagues relay experiences with
examiners who demand unreasonably aggressive writedowns and
reclassifications of viable commercial real estate loans and
other assets. The overreaching zeal of these examiners is
having a chilling effect on lending and an adverse impact on
the recovery. The Dodd-Frank Act, another result of the crisis,
is landmark legislation and will permanently alter the
landscape for financial services. The entire financial services
industry, including each community bank, will feel the effects
of this new law to some extent, some more than others.
The most troubling aspect of Dodd-Frank is the debit
interchange amendment. The law and the Federal Reserve's
proposed rule will fundamentally alter the economics of
consumer banking. Despite the statutory exemption for
institutions with less than $10 billion in assets, a provision
many Senators thought would help community banks, we believe
small financial institutions cannot be effectively carved out.
Small issuers will feel the full impact of the Federal Reserve
proposal over time.
To use my bank as an example, last year we had about 6,250
debit cards outstanding. If the Federal Reserve proposal goes
into effect, I estimate as much as $237,000 in reduced
revenue--lost income we would have to make up through higher
fees or product elimination.
ICBA strongly supports S. 575, the Debit Interchange Fee
Study Act of 2011, introduced by Senators Tester and Corker to
delay the implementation of the rule and give the Federal
Reserve 2 years to study the impact on small issuers and
consumers.
Community bankers are also concerned with the new Financial
Protection Bureau. While we are pleased that Dodd-Frank allows
community banks with less than $10 billion in assets to
continue to be examined by their primary regulators, we remain
concerned about CFPB regulations. Particularly, the CFPB should
not draft any rules to hamstring the ability of community banks
to customize products to meet customer needs. ICBA supports
amending the law to give prudential regulators a more
meaningful role in CFPB rule writing.
Finally, well before the financial crisis, ICBA has long
expressed concerns about too-big-to-fail banks and the moral
hazard they pose. Every community banker knows how difficult it
is to compete against megabanks whose too-big-to-fail status
gives them unique funding advantages. For this reason, we are
pleased the Dodd-Frank Act takes steps to diminish too big to
fail. Powerful interest groups are lobbying doggedly to
undermine the too-big-to-fail provisions of Dodd-Frank. This
part of the law is essential to creating a robust and
competitive financial services sector to the benefit of
consumers, businesses, and the economy.
Chairman Brown and Ranking Member Corker, many thanks for
convening this important hearing today. Community banks face
significant challenges in the months ahead. Community banks are
ready to navigate these choppy waters to better serve our
communities and promote the economic recovery--a goal we share
with this Committee.
Thank you for hearing our concerns. We look forward to
working with you.
Chairman Brown. Thank you, Mr. Loving.
Mr. Whittaker.
STATEMENT OF TOMMY G. WHITTAKER, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, THE FARMERS BANK, PORTLAND, TENNESSEE, ON BEHALF OF
THE AMERICAN BANKERS ASSOCIATION
Mr. Whittaker. Thank you, Senator Corker, for your
introduction. Chairman Brown, Ranking Member Corker, and
Members of the Subcommittee, my name is Tommy Whittaker. I am
President and CEO of The Farmers Bank in Portland, Tennessee.
Thank you for the opportunity to testify today. These are very
important issues for the thousands of community banks that work
hard every day to serve our communities.
The health of banks and the economic strength of our
communities are closely interwoven. A bank's presence is a
symbol of hope, a vote of confidence in a town's future. This
connection is not new. Most banks have been in their
communities for decades. Next year, The Farmers Bank will be
celebrating a century of service to our community. In fact, two
of every three banks have served their communities for more
than 50 years, and one of every three has been in business for
more than a century. These numbers tell a dramatic story about
banks' commitment to the communities they serve.
Banks are working hard every day to make credit available
in their communities, efforts that are made more difficult by
the hundreds of new regulations expected from the Dodd-Frank
Act and the constant second-guessing by bank examiners.
Managing all the new regulation will be a challenge for a bank
of any size, but for the medium-sized bank with only 37
employees, it is overwhelming. Let me give you a few examples
of how Dodd-Frank will negatively impact small banks.
First, the Government has inserted itself in the day-to-day
business of banking, which will mean less access to credit and
banking services. The most egregious example is the price
controls on interchange fees, which will devastate retail bank
profitability, stifle innovation, and force some people out of
the protection of the banking system. Some will say that the
so-called carve out for community banks from the Fed's
interchange rule will protect community banks. Nothing could be
further from the truth. Having two different prices for the
exact same product is not sustainable. The result for small
banks is a loss of market share and a loss of revenue that
supports services like free checking. ABA is grateful for the
willingness of Senators Tester and Corker and the many other
cosponsors of S. 575, to reconsider the harmful consequences of
the Fed's interchange proposal. More time to study the impact
of this provision is definitely warranted and ABA strongly
supports this bill.
Second, the cumulative burden of hundreds of new
regulations will lead to a massive consolidation of the banking
industry. Of particular concern is the additional compliance
burden expected from the Bureau of Consumer Financial
Protection. This new bureaucracy will impose new obligations on
community banks that have a long history of serving consumers
fairly in a competitive environment. One claim is that small
banks are exempt from the new Bureau, but small banks are not
exempt. All banks, large and small, will be required to comply
with all rules and regulations set by the Bureau. Bank
regulators will enforce these rules as aggressively as the
Bureau. The Bureau should focus its energies on supervision and
examination of nonbank financial providers. This lack of
supervision of nonbanks contributed mightily to the financial
crisis. We urge Congress to ensure that this focus on nonbanks
is a priority of the Bureau.
Third, some rules under Dodd-Frank will drive banks out of
some business loans. For example, the mortgage risk retention
rules proposed last week will shut many borrowers out of the
mortgage market and will drive some community banks out of
mortgage lending completely. ABA urges Congress to use its
oversight authority to ensure that the rules adopted will not
have adverse consequences for mortgage credit availability.
Ultimately, it is consumers that bear the consequences of
Government restrictions. More time spent on Government
regulations means less time devoted to our communities. The
consequences for the economy are severe. These impediments
raise the cost and reduce the availability of credit. Fewer
loans mean fewer jobs, and fewer jobs mean slower economic
growth. Since banks and communities grow together, limits on
one means limits on the other.
The regulatory burden from Dodd-Frank must be addressed in
order to give all banks a fighting chance to maintain long-term
viability. Each bank that disappears from the community makes
that community poorer. It is imperative that Congress take
action to help community banks do what they do best, namely,
meet the credit needs of their communities.
Thank you for the opportunity to present the views of ABA,
and I would be happy to answer any questions you may have.
Chairman Brown. Thank you, Mr. Whittaker.
Mr. Reed.
STATEMENT OF PAUL REED, PRESIDENT, THE FARMERS BANK AND SAVINGS
COMPANY, POMEROY, OHIO, ON BEHALF OF THE OHIO BANKERS LEAGUE
Mr. Reed. Mr. Chairman, Ranking Member Corker, Members of
the Financial Institutions Subcommittee, my name is Paul Reed.
I am President and CEO of The Farmers Bank in Pomeroy, Ohio, a
$250 million bank located along the Ohio River, and I am
testifying this afternoon on behalf of the Ohio Bankers League,
an association representing most of Ohio's banks and thrifts.
I wish I had more time to tell you about the great people I
work with in community banks. Community bankers are invested
financially and otherwise in the areas they live. Our customers
are our friends, and we gladly help them buy their first home,
start small businesses, and lay the groundwork for future
prosperity. We are proud of the role of trusted advisor we play
in so many households.
That pride is one reason the recent turmoil and Wall Street
bailouts have been so hard for us to stomach. As many of you
are aware, community banks largely did not participate in the
shoddy business practices that have been exposed in dramatic
fashion. Our business model is different from the largest
institutions, whose goal is often the deal rather than the
success of the business being financed, and we believe that
taking unfair advantage of our customers to pad our bonuses
makes no sense. It does not help our community prosper, and the
fate of a community bank is tied to the health of its
community.
Recent debate has caused me to wonder if community banking
matters to Congress. For the reasons I have already mentioned
and for more I could discuss in the time allotted, it should.
Robert Frost famously said, a bank is a place where they loan
you an umbrella in fair weather and ask for it back when it
begins to rain. I do not believe Mr. Frost was talking about a
community bank.
We are small business lenders who know our customers and
are willing to work with them to help them to survive
downturns, to grow and prosper when things improve. There was
no pull-back from us in offering credit when the economy
turned. We were eager to help, modifying loan terms and working
in partnership with our customers to limit the damage to them
and to us.
If I could speak frankly to the Committee, many, if not
all, of us have been frustrated by recent actions that have
relegated us to the sidelines in the credit market, unable to
help our local economies grow. It is no secret that small
businesses create a majority of job growth, and diminishing the
contribution community banks make to small business would be a
serious error.
I have concerns about Dodd-Frank and its effect on
community banking. Many features of the legislation create
obstacles to smaller banks. While the change in the calculation
of deposit insurance was a step in the right direction and we
welcome the effort to level the playing field, the FDIC has
since increased its target reserve ratio by 60 percent, meaning
deposit insurance premiums will be historically high for a very
long time. Please consider that every dollar I pay in deposit
insurance translates into roughly $10 that I cannot lend to
businesses in my community.
Dodd-Frank also includes an amendment which jeopardizes
trust preferred securities as a means of funding for community
banks. Some failed banks invested in poorly underwritten trust
preferred securities which caused losses to the FDIC. The
amendment was a reaction to these losses, but I believe a
better answer would have been to improve the instrument rather
than remove it from our tool kit.
And while Dodd-Frank exempted community banks from price
controls on debit card interchange fees, it left the choice of
processor to the retailer. In practice, I fear the exemption
will prove to be fiction. I would point out that interchange
income is used for free checking accounts, convenient branches,
and more ATMs. I estimate my interchange revenue will be
roughly one-fourth of my expense. Home Depot's Chief Financial
Officer recently told financial analysts the changes will
translate into $35 million in windfall profits annually to her
shareholders. Her comments seem to cast doubt on benefit to
consumers.
I welcome Dodd-Frank's intention to end ``too big to
fail.'' It was long overdue. However, the Wall Street Journal
reports that the funding costs of the biggest institutions are
still well below that of community institutions like mine,
causing me to wonder if the market believes ``too-big-to-fail''
is no longer true. Instead of ending ``too big to fail,'' the
sheer mass of new regulations required by Dodd-Frank may forge
an environment where many good community banks are ``too small
to survive.''
Congress created the Consumer Financial Protection Bureau
with the right goal, but a substantial percentage of financial
service providers were exempted, many of whom offer direct and
functional substitutes for what I offer. While my institution
has an exemption from direct supervision, understand that
whenever a rule changes, community banks face a huge burden. No
compliance examiners visited my nonbank competitor's office in
the past. The exemptions included mean there is little reason
to believe they will now.
Finally, I would submit that the consumer and country might
be better served by more logically dividing jurisdiction over
FDIC-insured institutions. The creation of a community bank
regulator with jurisdiction over both small commercials and
thrifts would be helpful, as protecting the public interest in
a multinational institution is a very different mission than in
my bank. It would eliminate the differences inherent with
multiple regulators. Today, the OTS, the OCC, the FDIC, and Fed
all oversee some category of community banking. Our public and
industry would be better served with a regulator that is
experienced and familiar with the unique aspects of our
industry.
And finally, Mr. Chairman and Ranking Member Corker, I
realize that hearing testimony is a routine part of your job,
but please allow me to express my gratitude for being able to
speak to the Committee on such important matters. I hope you
will find my comments useful as you continue your work, and I
would be happy to answer any questions.
Chairman Brown. Thank you, Mr. Reed.
The vote is about to be called, so I think Senator Corker
and I will be brief and hope that Senator Toomey and Senator
Moran get to questions, too.
First of all, thank you, Mr. Reed, for your service in
Southeast Ohio, a particularly economically troubled part of
the State for a long time, as you know, and thanks for what you
do to get credit to businesses as this economy slowly begins to
grow and the challenges you face.
You had said, I thought, something pretty interesting, Mr.
Loving. You talked about the difficulty of competing with
megabanks and then you mentioned that megabanks--your
discussion of megabanks lobbying the regulators on the issue of
``too big to fail.'' What do you most fear that the megabanks
will convince the regulators to go in a certain direction? Give
me two or three of your starkest fears, perhaps, about what
might result from that as it affects community banks and as it
affects the economy and as it affects ``too big to fail,'' in
any direction you want to go.
Mr. Loving. We, I think--as indicated, there is a concern
there, because, obviously, as the megabanks grow, that creates
more competition for the community banks, and with the
competitive advantage that they have from a pricing perspective
already. It takes away the ability of the community bank to
compete. And then as we have heard, the community bank is the
lifeblood of the community itself, particularly a small rural
community. And so if the opportunity to compete for price is
not there, I would have some concerns on the ability to meet
the needs of the consumer and the customer.
Along those same lines, I think in its continued growth of
the marketplace. You mentioned earlier in the hearing the
growth that has taken place since the financial crisis. I think
we need to look at that particular area and make sure it does
not continue to grow to decrease competition.
Chairman Brown. Thank you.
Senator Corker.
Senator Corker. Thank you, Mr. Chairman, and our apologies
to all of you. We thank you for your testimony, much of which,
I will say, will be very quotable on the Senate floor, and I
thank you for doing that.
I do want to make note that we have seven witnesses, four
regulators, three bankers. All have castigated the Durbin
Amendment. All have asked us to look at it with more study, and
I hope we will be able to cause that to happen in this body.
I will give you a quick yes-no question. Is it fact or myth
that the regulators that you deal with, whoever they are, are
continuing to regulate in such as manner that is keeping you
from making loans to otherwise very creditworthy deals and/or
clients? Yes or no?
Mr. Reed. Yes.
Mr. Whittaker. Senator, I have not had an examination in
about 18 months. We are about to have one when I get back to
Portland, Tennessee, by the way. But our bank has done well and
we really, in all honesty, have not had a lot of trouble with
the regulators. But hopefully, that says a little bit more
about my bank than anything else, but we are due to have an
examination when I get back in.
Senator Corker. Thank you.
Mr. Loving. I would agree. Our last examination was a good
examination, but what we are hearing across the country from
colleagues is that there is some concern about the oversight.
Mr. Reed. If I could add, we just finished--recently
finished an FDIC exam. They complimented our earnings. They are
not seeing similar banks with an ROA above 1 percent. But I
could not get over the intense focus on what seemed to be very
small issues. I was left wondering about the exam's priorities.
One examiner held a lengthy conversation with our CFO to
talk about the rate of depreciation of wallpaper in a branch.
The amount of money was $250. At the time the wallpaper had
already fully depreciated. And we had relatively little
conversation during that same exam about our largest commercial
loans.
Two other examples, of whether the exam has the right
focus, I do not mean to be critical of the examiners. I think
they were doing what they were supposed to do. However, one
examiner had a 20-minute conversation with our Chief Lending
Officer on a $323 loan.
I think perhaps more relevant to your question on the
impact on small business lending was a loan to a 30-year
customer. Over the years they have run a great business. It has
been said that tough times do not last, tough people do. These
people have lasted. More recently though, they have suffered 2
years of negative financials for earnings. However, they are
current on their loan payments. Our examiners classified that
customer the same way as a bankrupt customer. We had to add
$150,000 to our provision by the way that the rules are set
with our methodology for loan loss. That $150,000 that we had
to beef up our loan reserve for what we believe to be a very
solid customer translates into $1.5 million of loans to other
businesses cannot now make. And more important, our loan
committee and our board members will now ask the question, what
will the regulators think of this loan? rather than: is this a
good loan? Regulators now have dominate our decisions on what
is best for our community.
Senator Corker. Thank you so much. I appreciate your
testimony.
Chairman Brown. We have about 3 minutes, if Senator Moran
can ask a question. I apologize, Senator Toomey, and----
Senator Moran. Mr. Chairman, thank you. I would ask for
them to respond to my question in writing, but I would say that
it is interesting to me, Mr. Reed. That is very compelling
commentary. I smile because the two bankers who are expecting
examinations had a lot less to say than the banker who has
already experienced the exam----
[Laughter.]
Senator Moran. ----once again proving the prudence of a
community banker.
But I just would ask you, we often hear, or I often hear
from bankers about the regulators, the exams. What we need are
the specifics. It is hard to fight bureaucracy, but I think we
can do a better job if we have the specific rule or regulation
or example which we can take to the regulators, because as you
heard them express today, they are working hard to accommodate
community banks. We need the examples in which we can take to
them and say, this makes no sense. So if you or your
associations would be interested in providing me with an
example of something you would like for us to try to tackle, I
am certainly willing to work with my colleagues to do that.
Thank you, Mr. Chairman.
Chairman Brown. Thank you, Senator Moran. Senator Corker,
thank you, and Senator Toomey, if you can do 30 seconds of
something. I apologize.
Senator Toomey. That is quite all right. Thank you, Mr.
Chairman.
As until recently cochairman of the board of a community
bank of about $700 million in assets, I really worry about how
banks less than a billion dollars are going to be able to
afford the compliance costs, and I was wondering if, especially
Mr. Reed, if you could just comment on your concerns about the
survival of your bank, which last I saw was about $234 million.
Can a bank that size continue to afford if Dodd-Frank leads to
another set of rules that you have to comply with, even though
they do not inspect?
Mr. Reed. We kind of feel that a $250 million bank is
probably a threshold that will be safe. But I find it
interesting that we are in the process of renovating our main
office and we are now in designing a compliance department. We
have one full-time compliance examiner and a second one that
deals with suspicious activities and CTRs. We know that we need
to expand our staff to comply.
But I will say I want to speak on behalf of the little
guys. The State of Ohio has two banks with less than ten
employees. I do not know how it is going to be possible for
them to survive.
Chairman Brown. Thank you. We will have to adjourn. Again,
I apologize for truncating this hearing. The three of you
coming from West Virginia and Tennessee and Ohio and not living
near an airport. Mr. Reed, I appreciate you coming here and
cutting up--you are taking a whole day like this, and I
apologize for the shortness of the hearing, but thank you very
much.
Mr. Loving. Thank you.
Mr. Reed. Thank you.
Mr. Whittaker. Thank you.
Chairman Brown. We are adjourned. Thank you.
[Whereupon, at 4:15 p.m., the hearing was adjourned.]
[Prepared statements and additional material supplied for
the record follow:]
PREPARED STATEMENT OF MARYANN F. HUNTER
Deputy Director, Division of Banking Supervision and Regulation, Board
of Governors of the Federal Reserve System
April 6, 2011
Chairman Brown, Ranking Member Corker, and Members of the
Subcommittee, thank you for the opportunity to testify today on the
challenges and opportunities facing community banks. As a former
examiner and former head of banking supervision at the Federal Reserve
Bank of Kansas City, which has one of the highest numbers of community
banks in the Federal Reserve System, I am keenly aware of the critical
role that community banks play in their local communities. Community
banks also provide valuable insights into the health of their local
economies, which the Federal Reserve finds invaluable in determining
the appropriate path of monetary policy and in taking actions to
preserve the Nation's financial stability. Accordingly, I and my
colleagues at the Federal Reserve value our connection with community
banks and take very seriously our responsibility for the supervision of
these banks.
The Federal Reserve, in conjunction with our colleagues at the
State banking supervisory agencies, is responsible for supervising
approximately 830 State member banks. The vast majority of these banks
are community banks \1\ that provide traditional banking services and
loans to small businesses and consumers. In addition, the Federal
Reserve supervises more than 4,700 community bank holding companies,
which together control more than $2 trillion in assets and a
significant majority of the number of commercial banks operating in the
United States. Beginning in July 2011, the Dodd-Frank Wall Street
Reform and Consumer Protection Act (Dodd-Frank Act) will transfer
responsibility from the Office of Thrift Supervision to the Federal
Reserve for the supervision of more than 425 savings and loan holding
companies, most of which operate community thrifts. Given these
supervisory responsibilities--as well as the Federal Reserve's need to
fully understand regional economic conditions--we closely monitor the
condition and performance of community banks and appreciate the
opportunity to discuss with you today some of the factors affecting
their operations.
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\1\ For supervisory purposes, the Federal Reserve defines banking
organizations with assets of $10 billion or less as community banking
organizations.
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We gain considerable insight into community banking through our
supervisory, research, and outreach activities both at the Reserve
Banks and at the Board of Governors. Moreover, the Federal Reserve has
undertaken several recent initiatives to better understand the
perspectives of community banks and the challenges they face. The Board
recently established a special supervision subcommittee of Board
members that provides leadership and oversight on a variety of matters
related specifically to our supervision of community and smaller
regional banks. \2\ This subcommittee is chaired by Governor Elizabeth
Duke, a former longtime community banker, and also includes Governor
Sarah Bloom Raskin, previously the Maryland State banking commissioner.
A key role of this subcommittee is to review policy proposals to better
understand the effect that these policies and their implementation
could have on smaller institutions, both in terms of safety and
soundness and potential regulatory burden.
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\2\ For supervisory purposes, the Federal Reserve generally
considers banking organizations with assets between $10 billion and $50
billion to be regional banking organizations.
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The Federal Reserve also has undertaken an initiative to formalize
and expand its dialogue with community banks. In October 2010, the
Board announced the formation of the Community Depository Institutions
Advisory Council (CDIAC) to provide the Board with direct insight and
information from community bankers about the economy, lending
conditions, supervisory matters, and other issues of interest to
community banks. \3\ Council members share firsthand knowledge and
experience regarding the challenges they and their communities face, as
well as their plans to address these challenges. Each Reserve Bank has
its own local advisory council comprising representatives from banks,
thrift institutions, and credit unions, and one member from each local
council serves on the national council that meets with the Board twice
a year in Washington. Each of the local advisory councils has held its
first meeting, and the first meeting of the CDIAC with all of the
members of the Federal Reserve Board took place on Friday, April 1. We
expect these ongoing discussions will provide a particularly useful and
relevant forum for improving our understanding of the effect of
legislation, regulation, and examination activities on small banking
organizations.
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\3\ The CDIAC replaces the former Thrift Institutions Advisory
Council, which provided the Board with information from the perspective
of thrift institutions and credit unions.
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State of Community Banking
The economic downturn has had a significant impact on community
banks and, unfortunately, many continue to struggle. Although community
banks recorded an aggregate profit for 2010, one in every five
community banks reported a loss. This weakness stemmed mainly from
elevated loan losses and the need to bolster reserves in anticipation
of future loan deterioration. Provisions for loan losses were down
considerably from 2009 but remained near historically high levels.
There are some positive signs, however. For example, the pace of
deterioration in loan quality continued to slow during the fourth
quarter of 2010 and nonperforming assets \4\ fell for the third
straight quarter. However, the nonperforming assets ratio is still
higher than the levels that prevailed during the significant credit
downturn in the early 1990s. Loans secured by real estate continue to
be the main contributors behind poor asset quality, particularly loans
for construction and land development.
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\4\ Defined as nonaccruing loans plus other real estate owned.
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Although community banks have sharply reduced exposures to
commercial real estate lending--sometimes through heavy write-offs of
problem loans--many remain vulnerable to further deterioration in real
estate markets. The continued weaknesses in real estate markets offer
particular challenges to community banks, which secure much of their
lending with properties in their local markets. This has reduced a
significant source of revenue and has caused many banks to rethink
their operating models and seek alternative sources of revenue in new
lending segments.
As they seek to work through loan problems with their borrowers and
implement guidance issued by the supervisory agencies in 2009,
community banks have continued to actively restructure loans to
creditworthy borrowers who are experiencing financial difficulties.
During the past year, loans restructured and in compliance with
modified terms have increased more than 30 percent to $15.1 billion.
This includes $3.5 billion in restructured residential mortgages. We
believe these efforts will contribute to the recovery of many
struggling banks and the preservation of many small businesses, but
significant improvement in financial conditions will likely take
considerable time for many community banks. Indeed, although banks have
been aggressive in charging off losses on problem loans and
restructuring loans to borrowers experiencing financial difficulties,
the adequacy of loan loss reserves remains an ongoing supervisory
focus. As a consequence, reserves may require further strengthening and
loan loss provisions will likely continue to weigh on earnings in
future quarters at many banks.
Disappointingly, outstanding loan balances have declined for nine
consecutive quarters for community banks as a group, as they have for
the banking system as a whole. However, we have seen evidence that many
healthy community banks have continued to lend to creditworthy
borrowers. While lending contracted overall from mid-2008 through 2010,
this contraction was not uniform; a significantly higher proportion of
smaller banks (in this case, those with assets of $1 billion or less)
actually increased their lending during this period than was the case
for larger banks.
Community banks have reported a number of potential causes for the
low level of lending, including reduced loan demand, a tightening of
underwriting standards, a lack of creditworthy borrowers, declining
collateral values, and high levels of problem loans. They have also
frequently raised concerns about what they characterize as heightened
supervisory expectations for capital, liquidity, and the management of
concentrations in loans secured by commercial real estate, which some
bankers say are leading them to make fewer loans. We take these
concerns seriously and have worked hard to ensure that examiners are
well-trained and employ a balanced approach to bank supervision. For
example, following the issuance of the interagency Policy Statement on
Prudent Commercial Real Estate Loan Workouts in October 2009, \5\ an
intensive training effort was conducted for examiners across the
Federal Reserve System to promote consistency and balance in reviewing
bank workouts of troubled commercial real estate loans. We have also
undertaken a number of initiatives through our community affairs
functions across the Federal Reserve System to encourage lending to
creditworthy small businesses and consumers.
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\5\ See, Board of Governors of the Federal Reserve System,
Division of Banking Supervision and Regulation (2009), ``Prudent
Commercial Real Estate Loan Workouts'', Supervision and Regulation
Letter 09-7 (October 30), www.federalreserve.gov/boarddocs/srletters/
2009/SR0907.htm.
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On a final note, community bankers and their supervisors have also
been increasing their attention to other areas where lending
concentrations may exist. For instance, both the Federal Reserve and
many community banks are monitoring developments in agricultural
lending to ensure that underwriting standards are consistent with
assessments of potential exposures to fluctuations in commodity prices
and land values.
Effects of Recent Legislation
In our interactions with community bankers, we consistently hear
that the changing regulatory environment is a key challenge and concern
for community banks. Even though recent reforms are directed
principally at the largest and most complex U.S. financial firms and
explicitly exempt small banks from the most stringent requirements,
community bankers remain concerned that expectations being set for the
largest institutions will ultimately be imposed in a burdensome manner
on smaller institutions or will otherwise adversely affect the
community bank model.
For example, bankers have brought several provisions of the Dodd-
Frank Act to our attention as particular areas of concern for community
banks. One such provision is the requirement that the Federal Reserve
issue a rule to limit debit card interchange fees and to prohibit
network exclusivity arrangements and merchant routing restrictions.
Many community bankers have also expressed a sense of uncertainty about
the rulemaking authority of the new Consumer Financial Protection
Bureau formed by the Dodd-Frank Act. Another concern is that the more-
stringent prudential standards \6\ that the Federal Reserve is required
to develop for banking firms with assets greater than $50 billion and
all nonbank financial firms designated as systemically important by the
Financial Stability Oversight Council might ultimately filter down to
smaller banks. In this regard, some concerns have been raised that the
new, international Basel III prudential framework for large, globally
active banks--which will require large banks to hold more and better-
quality capital and more-robust liquidity buffers--may be applied to
banks that are not systemic or internationally active. More generally,
community banks have raised concerns that the cost of compliance with
new regulations and requirements may fall disproportionately on smaller
banks that do not benefit from the economies of scale of larger
institutions, and that this may exacerbate consolidation of the banking
sector.
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\6\ These more-stringent standards for large institutions will
include stronger capital and leverage requirements, liquidity
requirements, and single-counterparty credit limits, as well as
requirements to periodically produce resolution plans and conduct
stress tests.
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In this regard, the Federal Reserve and the other Federal financial
supervisory agencies will be publishing all of the Dodd-Frank proposed
rulemakings for public comment. For example, last week the Federal
Reserve, in conjunction with other Federal agencies, \7\ issued a
proposed rule that would require sponsors of asset-backed securities to
retain at least 5 percent of the credit risk of the assets underlying
the securities and would not permit sponsors to transfer or hedge that
credit risk. We are aware that some community banks have expressed
concerns about the potential impact this proposed rule might have on
the availability of credit. We encourage public comments from community
banks and other commenters on this and all proposals, and will
carefully consider comments in drafting final rules.
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\7\ The other agencies are the Department of Housing and Urban
Development, Federal Deposit Insurance Corporation, Federal Housing
Finance Agency, Office of the Comptroller of the Currency, and
Securities and Exchange Commission. For more information, see Board of
Governors of the Federal Reserve System (2011), ``Agencies Seek Comment
on Risk Retention Proposal'', joint press release, March 31,
www.federalreserve.gov/newsevents/press/bcreg/20110331a.htm.
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Before concluding my remarks on the effects of recent legislation,
let me say a few words about the transfer of savings and loan holding
company supervisory authority to the Federal Reserve. We have been
working in close coordination with the Office of Thrift Supervision,
the Office of the Comptroller of the Currency, and the Federal Deposit
Insurance Corporation to prepare for this transfer. Our intent--to the
maximum extent possible and consistent with the Home Owners' Loan Act
and other laws--is to create an oversight regime for savings and loan
holding companies that is consistent with our comprehensive
consolidated supervision regime for bank holding companies, and we
intend to issue a public notice to this effect shortly. We appreciate
that savings and loan and bank holding companies differ in important
ways and will remain governed by different statutes. Federal Reserve
staff have been engaged in an active and constructive outreach effort
to savings and loan holding companies to better understand their unique
features and to help them understand our supervisory approach to
holding companies.
Resilience of Community Banks
These regulatory changes will provide a new set of challenges for
community banks. However, community banks have faced similar challenges
in the past and have performed effectively and continued to meet the
needs of their communities. Indeed, while much of the focus in recent
years has been on the inability of many community banks to withstand
intense credit and liquidity pressures, it is important to note that
many community banks supervised by the Federal Reserve remained in
sound condition throughout the crisis. Most of these banks entered the
crisis with moderate exposures to commercial real estate, moderate
loan-to-deposit ratios, and ample investment securities. They tended to
report solid earnings and net interest margins, very limited reliance
on noncore funding, and generally strong capital levels throughout the
crisis. In summary, the banks that weathered the crisis most
effectively were those that adhered to the traditional community
banking model.
The performance of these banks provides perhaps the best example of
the resilience of the community bank model. Looking back over the
crisis, these banks operated safely, soundly, and profitably despite
the most challenging financial climate since the Great Depression. This
speaks to the skill of their management and the soundness of their
business models.
Conclusion
Community banks will continue to face a challenging environment for
some time as they work through financial difficulties brought on by the
economic downturn and face challenges that arise from a rapidly
changing regulatory environment. The unique connection between
community banks and the communities they serve is clear. The bankers
who live and work in these communities know their customers and
understand their local economies, and that knowledge is not easily
replaced or replicated. This relationship banking is crucial to the
community banking model and an important part of its viability. The
Federal Reserve will continue to listen to the concerns of community
banks and carefully weigh the impact of regulatory and policy changes
on them, while at the same time working with them to address the future
challenges they may face.
Thank you again for inviting me to appear before you today on this
important subject. I would be pleased to answer any questions you may
have.
______
PREPARED STATEMENT OF SANDRA L. THOMPSON
Director of Risk Management Supervision, Federal Deposit Insurance
Corporation
April 6, 2011
Chairman Brown, Ranking Member Corker, and Members of the
Subcommittee, I welcome the opportunity to speak with you today about
the state of community banking.
Community banks provide vital services in their communities; making
loans to customers they know, in markets they know. Community banks are
essential providers of credit to small businesses, and through the
recent financial crisis, community banks have maintained steadier
levels of total loan balances than their larger competitors. As our
economy recovers from the most severe recession since the 1930s, a
thriving community banking sector is important to help support the
credit needs of local households and business borrowers.
As the supervisor of 4,414 community banks, \1\ the FDIC has a keen
appreciation for the important role community banks play in the
national economy. The FDIC's bank examiners work out of duty stations
located in 85 communities across the country. They know the community
banks in their areas and are familiar with the local conditions facing
those banks. Many have seen more than one previous economic down cycle
and recognize the critical role that community banks play in credit
availability.
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\1\ Throughout this testimony, for purposes of data analysis,
community banks are defined as banks and thrifts with total assets of
less than $1 billion. The FDIC supervises a total of 4,715 banks. All
data are as of December 31, 2010.
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Over 90 percent of all FDIC-insured institutions are community
banks, and they hold close to 11 percent of aggregate industry assets.
Community banks have branches in nearly all towns and urban areas, and
about two-thirds of all branches in rural areas are community bank
branches. Through fast, localized decision making, personal service,
and a strong local presence, community banks serve the loan and deposit
needs of consumers and small businesses in periods of both economic
expansion and contraction.
In my testimony, I will describe the performance of community banks
as of year-end 2010, identify some of the challenges and opportunities
we see for community banks, and discuss some of the actions that the
FDIC has taken to help smaller institutions navigate the downturn.
Finally, I will discuss the effects of the Dodd-Frank Wall Street
Reform and Consumer Protection Act (the Dodd-Frank Act) on community
banks.
The Financial Performance of Community Banks
After an extremely challenging 2009, community banks reported
improving performance in 2010. Just as in the broader economy and in
the aggregate performance of larger banks, 2010 shows signs of marking
the beginning of a turnaround for community banks.
A number of community banks still face headwinds in the form of
legacy problems in their real-estate loan portfolios. These headwinds
are reflected in aggregate financial performance that continues to be
weaker than precrisis levels. Thus, while community bank earnings
rebounded from the aggregate loss reported in 2009, the average return
on assets remained low and lags that of larger banks. Asset quality
deterioration appears to have leveled off, but volumes of troubled
assets and charge-offs remain high. In addition, community banks
continue to have high concentrations of commercial real estate loans, a
market segment that remains weak in many areas of the country. A more
detailed discussion of community bank performance follows.
Earnings
Community banks earned $4.7 billion in 2010, in contrast to the net
loss that was reported for 2009. Fewer institutions reported annual
losses in 2010 than in the previous year, and two-thirds of community
banks had earnings improvement in 2010, compared to only 40 percent in
2009. Most community banks set aside smaller provisions for loan loss
in 2010 than they did the previous year, and lower funding costs helped
net interest margins rise slightly.
The average return on assets (ROA) for community banks in 2010 was
0.33 percent. While this was a clear improvement over the prior year's
loss, it was only half the overall banking industry's ROA of 0.66
percent, indicating that community bank performance continues to trail
that of larger banks. The difference in performance may be attributable
in part to large banks' more diversified revenue sources and to
differences in asset composition--community banks are more dependent
upon interest income from loans than their larger competitors are, and
community banks have higher loan-to-asset ratios than large banks.
Asset Quality
Asset quality is not recovering as quickly at community banks as at
larger banks. The ratio of noncurrent \2\ loans to total loans for
community banks fell very slightly during the fourth quarter, to 3.46
percent, and was flat compared to a year ago. Noncurrent rates and net
charge-off rates for community bank loan portfolios remain lower than
average industry rates, but this is a function of the differing mix of
loans between small and large institutions. The retail loans that make
up a larger portion of big banks' portfolios, such as credit card
loans, have relatively high noncurrent rates. However, these loans are
also recovering more quickly than the commercial real estate (CRE)
loans that make up a larger part of community banks' portfolios.
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\2\ Noncurrent loans are loans that are 90 or more days past due
or have been placed on nonaccrual status.
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The noncurrent rate for construction and development (C&D) loans at
community banks remained stubbornly high at 12.88 percent in the fourth
quarter and reflects the ongoing distress in the real estate
development sector. Noncurrent rates also rose during the fourth
quarter for one-to-four family residential real estate loans and
nonfarm nonresidential real estate loans, but declined for commercial
and industrial (C&I) loans.
Net charge-offs increased during the fourth quarter, but were lower
than a year ago (net charge-offs are typically higher in the fourth
quarter than in the preceding three quarters). Most community banks
reported declines in net charge-offs compared to fourth quarter 2009.
Community banks set aside more in provisions for loan losses than they
charged off during the quarter, suggesting that community banks will
continue to work through their asset quality problems in 2011.
As a result of the protracted credit quality problems, community
banks' levels of other real estate owned (ORE) and restructured loans
have increased. ORE represented 1.05 percent of assets at community
banks and restructured loans made up another 1.19 percent. Troubled
assets--ORE, restructured loans, delinquent, and noncurrent loans--
represented about 5 percent of assets.
Commercial real estate markets have been hard-hit in the crisis,
and it is no surprise that community banks with rapid growth or
exceptionally high concentrations of CRE lending, and especially C&D
lending, have suffered disproportionately. C&D loans and nonfarm
nonresidential real estate loans comprise 38 percent of community bank
loan balances, but during the fourth quarter represented 50 percent of
their loans charged-off, almost 60 percent of their noncurrent loans,
and close to three-fourths of their ORE. Given that real estate markets
continue to struggle in many regions across the country, troubled CRE-
related assets will continue to strain community banks' asset quality
and earnings throughout this year.
Lending by Community Banks
As I stated earlier, community banks play a vital role in credit
creation across the country and small businesses especially rely on
community banks for loans when large institutions and nonbanks curtail
their lending activity. This has been borne out by loan originations
over the past several years, as community bank loan balances have
increased by about 3 percent on a merger-adjusted basis since second
quarter 2008. Over the same period, overall industry loan balances fell
by more than 7 percent. It is also noteworthy to point out that
community banks held almost 39 percent of small loans to businesses
(C&I and CRE loans in amounts under $1 million and agricultural and
farmland loans under $500,000) at the end of 2010, which represents
about three times the community banks' share of total industry loans.
Funding and Capital
Consistent with their focus on providing traditional banking
services to retail customers, community banks rely heavily on deposits
to fund their balance sheets. Fourth quarter domestic deposits were
equal to more than 80 percent of assets at community banks, compared to
less than 60 percent of industry assets. Close to three-fourths of
community bank deposit accounts are in accounts under the insurance
limit of $250,000. Community banks held $53 billion in non- interest-
bearing transaction accounts over $250,000 temporarily insured under
the Dodd-Frank Act at the end of the fourth quarter. Again, the local
focus and convenience offered by community banks provides them with a
viable platform for gathering deposits, while delivering essential
depository and payment services to consumers and small businesses.
Community banks have maintained capital ratios higher than the
industry averages. Risk-based capital ratios rose for the fourth
straight quarter and the community bank leverage ratio was just below
the 2-year high.
Consolidation
At year-end 2010, there were 874 fewer FDIC-insured institutions
with assets under $1 billion than at year-end 2007, as continuing
consolidation and a number of failures have reduced the community bank
population. From year-end 2007 through year-end 2010, the share of
industry assets represented by community banks has declined from 11.4
percent to 10.8 percent, while the share of industry assets represented
by the largest banks (those with total assets greater than $100
billion) has increased from 54.6 percent to 59.1 percent. However,
consolidation of community banks is not primarily a result of the
recent crisis, but is the continuation of a long-term trend
precipitated by competition, technological advances, and innovation in
the financial services industry.
Challenges and Opportunities for Community Banks
The most important challenge facing community banks at present is
improving their operating performance amid the lingering effects of the
financial crisis and recession. A large number of financial
institutions have an elevated level of problem assets, which strains
earnings and can divert management's attention from executing longer-
term strategic initiatives. Moreover, communities across the country
continue to suffer from high unemployment and slow job creation, and
loan demand remains weak. According to the latest Federal Reserve
Senior Loan Officers' Opinion Survey, only 12 percent of small banks in
the survey reported increased demand for C&I loans. Tepid business
expansion and continuing high unemployment are also making it difficult
for businesses and consumers to service existing loans and for
financial institutions to work out problems.
Many community banks remain vulnerable to additional real estate
market declines as a result of their significant holdings of commercial
real estate assets, both as loans and as ORE. Many institutions that
relied heavily on C&D lending in the years leading up to the recession
continue to be exposed to declining home prices. At the same time,
commercial real estate markets remain weak in most areas.
In spite of the obstacles, and high concentrations of commercial
real estate loans, many community banks weathered the financial storm
well because of sound underwriting practices and corporate governance,
in addition to a keen understanding of their local market and economy.
As a result, those institutions are poised to respond quickly and
prudently once credit demand returns. These banks know their customers
well and in turn, their customers know them, trust them, and appreciate
their personal attention and responsiveness at the local level.
Community banks could also begin to see a narrowing of the cost
advantage that larger institutions had previously enjoyed. Many of the
reforms that are being implemented in response to the financial crisis
are aimed at improving lax underwriting practices, particularly in the
residential mortgage lending field. Community banks for the most part,
did not relax their standards. That made it difficult for them to
compete during the years of expansion leading up to the crisis. As both
nonbanks and larger institutions are required by the Dodd-Frank Act to
tighten standards, the community banks may see an improvement in their
ability to originate good quality mortgage loans at competitive
interest rates.
The FDIC and Community Banks
Throughout the real estate and economic downturn, the FDIC has
advocated for policies that will help community banks and their
customers navigate this challenging period and mitigate unnecessary
losses. We share community banks' desire to restore profitability,
strengthen asset quality, and serve the credit needs of local markets.
The FDIC has worked closely with banks as they have taken steps to
raise capital, enhance their loan workout functions, and revise
strategic plans to remain competitive in the financial services
industry. Through our regional and field offices, the Corporation
actively communicates with the community banks we supervise and
provides recommendations for addressing operational and financial
weaknesses as appropriate.
The FDIC has joined several interagency efforts that encourage
banks to originate and restructure loans to creditworthy borrowers, and
to clarify outstanding guidance. For example, the Federal bank
regulatory agencies issued the Interagency Statement on Meeting the
Needs of Creditworthy Borrowers on November 12, 2008, which encouraged
banks to prudently make loans available in their markets. The agencies
also issued the Interagency Statement on Meeting the Credit Needs of
Creditworthy Small Business Borrowers on February 12, 2010, to
encourage prudent small business lending and emphasize that examiners
will apply a balanced approach in evaluating loans. This guidance was
issued subsequent to the October 30, 2009, Policy Statement on Prudent
Commercial Real Estate Workouts that encourages banks to restructure
loans for commercial real estate mortgage customers experiencing
difficulties making payments. The CRE Workouts Guidance reinforces
long-standing supervisory principles in a manner that recognizes
pragmatic actions by lenders and small business borrowers are necessary
to weather this difficult economic period.
The FDIC also joined the other banking agencies in issuing the
Interagency Appraisal and Evaluation Guidelines on December 2, 2010, to
clarify expectations for real estate appraisals. Clarification of these
guidelines was important for the industry given changes in property
values over the past several years. We also actively engage with
community banks at the State level and nationally through various trade
associations, which helps our agency articulate its supervisory
expectations on important issues through a variety of forums. We also
sponsor training events for community banks including regional and
national teleconferences on risk management and consumer protection
matters, as well as Directors Colleges to help bank directors better
understand the supervisory process.
Potential Impact of the Dodd-Frank Act
Some community bankers have pointed to uncertainty about the effect
of new regulations under the Dodd-Frank Act as a potential obstacle to
their continued profitability.
However, much of the Dodd-Frank Act should have no direct impact on
community banks, while certain changes in the Act provide real
benefits. For example, those provisions of the Act that impose
additional capital and other heightened prudential requirements on the
largest financial institutions are aimed at reducing systemic risks. If
properly implemented, those and other provisions of the Act should do
much to return competitive balance to the marketplace by restoring
market discipline; ensuring appropriate regulatory oversight of
systemically important financial companies; and having rules that apply
to all providers of financial services, not just insured depository
institutions. In fact, as noted above, there are immediate, tangible
benefits that the Dodd-Frank Act confers on community banks.
First, the deposit insurance coverage limit was permanently
increased to $250,000. In addition, the law provides a guarantee of all
balances in non- interest-bearing transaction accounts above $250,000
until the end of 2012. These changes help to address one of the main
sources of competitive imbalance, by giving community banks access to
federally insured or guaranteed funding in larger amounts, without
having to pay a fee to deposit brokers or consultants.
The Dodd-Frank Act also changes the assessment base used to
calculate premiums paid to the Deposit Insurance Fund (DIF), from one
based on deposits to one based on total assets. Because community banks
generally rely more on deposits as a funding source than do larger
banks, the Dodd-Frank Act effectively shifts a greater proportion of
DIF assessments to larger banks. In aggregate, banks with assets under
$10 billion should see their assessments decline by 30 percent. The
final rule implementing the new assessment base took effect on April
1st.
To provide for a more stable DIF going forward, the law increases
the minimum DIF reserve ratio to 1.35 percent. But it extends the
period in which the DIF must be recapitalized to 2020, and also
requires that the assessments needed to increase the DIF from the old
minimum ratio of 1.15 percent to the new minimum ratio of 1.35 percent
should be collected entirely from banks with total consolidated assets
of $10 billion or more. Thus, community banks' deposit insurance
assessments will not need to rise in order to meet the new target.
There are other important, if less tangible, ways that the Dodd-
Frank Act should help create a more level playing field between
community banks and their larger competitors.
Most--but not all--of the high risk mortgage lending that
precipitated the recent crisis originated outside of insured banks. The
Dodd-Frank Act requires these nonbank lenders to adhere to Federal
consumer protection laws and places them under Federal supervision for
the first time. The Consumer Financial Protection Bureau established by
the Dodd-Frank Act will likely reduce the unfair competitive advantage
that nonbank competitors have long enjoyed as under-regulated--and
often unregulated and unsupervised--financial services providers.
Importantly, section 171 of the Dodd-Frank Act, the Collins
Amendment, places a risk-based capital floor under the so-called
advanced approaches. The floor will ensure that capital requirements
for the largest banks and their bank holding companies are no lower
than the level of capital required of community banks that hold similar
exposures. In addition, under section 165 of the Act, large bank
holding companies are subject to heightened capital standards (that is,
beyond the standards required of smaller institutions), to account for
the greater risk that large bank holding companies pose to the
financial system. These provisions of the Dodd-Frank Act are consistent
with developments taking place in the Basel Committee on Banking
Supervision which, with the support of the U.S. banking agencies, has
announced its intention to develop heightened capital standards for the
largest banks.
Finally, the most fundamental reform in the Dodd-Frank Act is the
new orderly liquidation authority for large bank holding companies and
systemically important nonbank financial companies, which ends ``Too
Big to Fail.'' The FDIC regularly carries out a prompt and orderly
liquidation process using its receivership authority for insured banks
and thrifts that are facing insolvency. The Dodd-Frank Act for the
first time gives the FDIC a similar set of receivership powers to close
and liquidate systemically important financial firms that are failing.
Just as important, the Act mandates that systemically important
financial institutions maintain credible, actionable resolution plans
that facilitate their orderly resolution if they should fail. If the
FDIC and the Federal Reserve Board do not find an institution's
resolution plan to be credible, we can compel the divestiture of
activities that would unduly interfere with the orderly liquidation of
the company. The FDIC Board adopted a proposed rulemaking for public
comment last week and as Chairman Bair said at the Board meeting,
``This is a big step forward in ending `too big to fail.' ''
It has been well-documented that the cost of funds for the largest
banks has been lower than that for smaller banks. In fourth quarter
2010, the average cost of funding earning assets for banks over $100
billion in assets was 0.67 percent, compared to 1.24 percent for
community banks. Not all of this difference is due to the perception
that the largest banks are too big to fail. Their product mix and
access to capital markets in the U.S. and overseas help to lower their
funding costs in low interest rate environments, such as the one we are
in.
Using the tools provided under the Dodd-Frank Act, we can break
this cycle of subsidized risk taking and create a financial marketplace
that is both more stable and more competitively balanced. Much of the
regulatory cost of the Dodd-Frank Act will fall, as it should, directly
on the large institutions that create systemic risk. The leveling of
the competitive playing field will help preserve the essential
diversity of our financial system, and prevent any institution from
taking undue risks at the expense of the public.
The FDIC understands why community banks are wary. We recognize the
concerns community bankers have in understanding how new legislation
and regulations will affect their operations. The FDIC is required or
authorized by Congress to implement some 44 regulations, including 18
independent and 26 joint rulemakings. Community banks should be, and
are, taking an active interest in these new regulations as they are
developed.
We are implementing the provisions of the Dodd-Frank Act as
transparently and expeditiously as possible. Not only is the FDIC
following the normal steps used in any rulemaking process, we are also
holding public roundtables to discuss issues such as our systemic
resolution authority and required resolution plans, the new deposit
insurance assessment provisions and core/brokered deposits. In
addition, we document meetings between senior FDIC officials and
outside parties that are related to the implementation of the Dodd-
Frank Act.
The FDIC also is focused on how other provisions of the Dodd-Frank
Act could impact community banks. For example, we are extremely
concerned that, under proposed regulations, community banks may not
actually receive the benefit of the interchange fee limit exemption
explicitly provided for in the law. We sent a comment letter to the
Federal Reserve Board detailing these concerns and encouraging the
Federal Reserve to consider the practical implications of its proposed
rule on community banks.
We also have engaged the FDIC's Advisory Committee on Community
Banking on the Dodd-Frank Act and other issues. At the January 20
meeting of the committee, there was a discussion of ways to ease the
regulatory burden on small institutions. Among the ideas discussed at
that meeting were identifying which regulatory questionnaires and
reports can be streamlined through automation, reviewing ways to reduce
the total amount of reporting required of banks, and ensuring that
community banks are aware that senior FDIC officials in the regions and
in Washington are available and interested in receiving their feedback
regarding our regulatory and supervisory process.
The FDIC is particularly interested in finding ways to eliminate
unnecessary regulatory burden on community banks, whose balance sheets
are much less complicated than those of the larger banks. We
continuously pursue methods to streamline our supervisory process
through the use of technology and other means to reduce any possible
disruption associated with examination activity. While we maintain a
robust examination process, we are sensitive to banks' business
priorities and strive to be efficient in our work.
To this end, we have established as a goal for the first quarter of
2011 to modify the content of our Financial Institution Letters
(FILs)--the vehicle used to alert banks to any regulatory changes or
guidance--so that every FIL issued will include a section making clear
the applicability to smaller institutions (under $1 billion). In
addition, by June 30 we plan to complete a review of all of our
recurring questionnaires and information requests to the industry and
to develop recommendations to improve the efficiency and ease of use
and a plan to implement these changes. The FDIC also has challenged its
staff to find additional ways of translating some of these ideas into
action. This includes launching an intensive review of existing
reporting requirements to identify areas for streamlining.
At the beginning of this year, we initiated a dialogue with our
field and regional staffs to reinforce the FDIC's balanced approach to
bank supervision. In this effort, we are reminding examiners to work
cooperatively with financial institutions and to be aware of the great
challenges that face community banks. Moreover, we will be engaging in
a dialogue with bankers at each examination in 2011 to solicit bankers'
views on aspects of the regulatory and supervisory process that may be
adversely affecting credit availability.
Conclusion
Community banks remain an essential part of the financial system,
and the FDIC is committed to a regulatory structure that will support a
vibrant, competitive community banking sector and a level playing field
between large and small banks. Throughout the financial crisis and
recession, community banks continued providing credit even as larger
banks pulled back. We need a thriving community banking sector to
support an economic recovery and fulfill the credit and depository
needs of households and businesses on Main Street.
Thank you. I am pleased to answer any questions.
______
PREPARED STATEMENT OF JENNIFER KELLY
Senior Deputy Comptroller for Midsize and Community Bank Supervision,
Office of the Comptroller of the Currency
April 6, 2011
I. Introduction
Chairman Brown, Ranking Member Corker, and Members of the
Subcommittee, my name is Jennifer Kelly. I have been a commissioned
national bank examiner for 27 years, and I am currently the Senior
Deputy Comptroller for Midsize and Community Bank Supervision for the
Office of the Comptroller of the Currency (OCC), reporting directly to
the Comptroller. In this capacity, I serve as the senior OCC official
responsible for community bank supervision. I appreciate this
opportunity to discuss the current state of the community banks the OCC
supervises and the impact of the Dodd-Frank Wall Street Reform and
Consumer Protection Act (Dodd-Frank Act) on those institutions.
My testimony first presents an overview of the OCC's approach to
the supervision of national community banks, then addresses the present
state of community banks, and concludes by sharing our perspective on
the likely effects of the Dodd-Frank Act on community banks.
Let me say first that community banks play a crucial role in
providing consumers and small businesses in communities across the
Nation with essential financial services as well as the credit that is
critical to economic growth and job creation. While we have been
through an extremely difficult economic cycle that has been challenging
for institutions of all sizes, I am pleased to report that conditions
are beginning to stabilize for community banks, and we are seeing these
institutions return to profitability. As a result, the vast majority of
these banks will continue to play a vital role in supporting their
communities and the Nation's financial system.
II. OCC's Approach to Community Bank Supervision
The OCC supervises over 1,200 community banks with assets under $1
billion; more than 800 of those banks have less than $250 million in
assets. On July 21, in accordance with the Dodd-Frank Act, the OCC will
assume responsibility for the supervision of approximately 664 Federal
savings associations--including 220 mutuals--with total assets of just
over $912 billion. Since the overwhelming majority of those thrifts are
community institutions, the number of community institutions we
supervise will increase by more than half later this year. These
institutions are integral to local economies throughout the country,
and we remain deeply committed to their safe and sound operation.
The OCC's community bank supervision program is built around our
local field offices. Approximately 75 percent of our examination staff
is dedicated to the supervision of community institutions. These
examiners are based in over 60 cities throughout the United States in
close proximity to the banks they supervise. Every national community
bank is assigned to an examiner who monitors the bank's condition on an
ongoing basis and who serves as the focal point for communications with
the bank. The primary responsibility for the supervision of individual
community banks is delegated to the local Assistant Deputy Comptroller
(ADC), who is under the oversight of a district Deputy Comptroller who
reports to me. When we assume responsibility for Federal savings
associations later this year, we will increase the number of ADCs by
more than 20 and open additional field offices.
Our structure ensures that community banks receive the benefits of
highly trained bank examiners with local knowledge and experience,
along with the resources and specialized expertise that a nationwide
organization can provide. While our bank supervision policies and
procedures establish a common framework and set of expectations, our
examiners are taught to tailor their supervision of each community bank
to its individual risk profile, business model, and management
strategies. As a result, our ADCs are given considerable decision-
making authority, reflecting their experience, expertise and their
``on-the-ground'' knowledge of the institutions they supervise.
We have mechanisms in place to ensure that our supervisory
policies, procedures, and expectations are applied to community banks
in a consistent and balanced manner. Every report of examination is
reviewed and signed off by the responsible ADC or Deputy Comptroller
before it is finalized. In those cases where significant issues are
identified and an enforcement action is already in place, or is being
contemplated, additional levels of review occur prior to finalizing the
examination conclusions. We also have formal quality assurance
processes that assess the effectiveness of our supervision and
compliance with OCC policies through periodic, randomly selected
reviews of the supervisory record. This is done with oversight by the
Enterprise Governance Unit that reports directly to the Comptroller.
A key element of the OCC's supervisory philosophy is open and
frequent communication with the banks we supervise. In this regard, my
management team and I encourage any banker that has concerns about a
particular examination finding to raise those concerns with his or her
examination team and with the district management team that oversees
the bank. Our ADCs and Deputy Comptrollers expect and encourage such
inquiries. Should a banker not want to pursue those chains of
communication, our Ombudsman's office provides a venue for bankers to
discuss their concerns informally or to formally request an appeal of
examination findings. The OCC's Ombudsman is fully independent of the
supervisory process, and he reports directly to the Comptroller. In
addition to hearing formal appeals, the Ombudsman's office provides
bankers with an impartial ear to hear complaints and a mechanism to
facilitate the resolution of disputes with our supervisory staff.
The OCC recognizes the importance of communicating regularly with
the industry outside of the supervision process to clarify our
expectations, discuss emerging issues of interest to the industry, and
respond to bankers' concerns. We participate in numerous industry-
sponsored events, as well as conduct a variety of outreach activities,
including Meet the Comptroller events, chief executive officer
roundtables, and teleconferences on topical issues. We also offer
workshops for bank directors to help them understand and effectively
execute their fiduciary responsibilities. In preparation for the
transfer of Federal savings associations to OCC supervision next July,
we recently presented 17 day-long programs for thrift executives in
locations around the country to provide information and perspective on
the agency's approach to supervision and regulation.
III. Current Condition of National Community Banks
The operating environment for community banks over the last 3 years
has been particularly challenging. Lending activity--the primary
revenue source for community banks--has been hampered by the overall
economic climate. Although it is true that many bankers have adjusted
and tightened some of their credit underwriting standards, most of the
community bankers I talk to reiterate that lending is the backbone of
their business and that they are seeking to make loans to creditworthy
borrowers. We continue to encourage bankers to lend to such borrowers.
As shown in Chart 1, community bank profitability, as measured by
return on equity, improved last year after a precipitous decline in the
previous 2 years but remains sharply below historical experience.
A major factor contributing to the decline in profitability is the
continued pressure on community banks' net interest margins. Tepid loan
demand and the low interest rate environment are contributing to the
decline in these margins: as loans and investments mature, banks are
forced to replace them with lower yielding assets. While the rates
banks pay for certificates of deposit and other funding sources have
also declined, many core deposits are already at extremely low rates,
leaving little room for further declines. As a result, community banks'
margins are at historical lows (See, Chart 2).
Elevated levels of problem loans are also hampering community
banks' financial performance as banks have had to increase their loan
loss reserve provisions to cover loan losses. As shown in Chart 3 on
the next page, the net effect of these factors has been a strain on
community banks' net income.
Although similar trends are evident for the entire industry, they
pose more difficult challenges for small institutions because large
banks have more diverse revenue streams and greater economies of scale.
When margins are under pressure, other sources of revenue take on
greater prominence. But those other sources of income are also under
pressure right now.
Notwithstanding these pressures, the vast majority of national
community banks remain strong: three-quarters of the community banks we
supervise have supervisory--or CAMELS--ratings of 1 or 2, reflecting
their sound management and strong financial condition. \1\ These banks
have successfully weathered the recent economic turmoil by focusing on
sound banking fundamentals: strong underwriting practices, prudent
limits on loan concentrations, and stable funding bases.
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\1\ The Uniform Financial Institutions Rating System is commonly
referred to as CAMELS. CAMELS is an acronym that is drawn from the
first letters of the individual components of the rating system:
Capital adequacy, Asset quality, Management, Earnings, Liquidity, and
Sensitivity to market risk.
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There remains, however, a sizeable segment of community banks that
are experiencing more severe financial strains, primarily due to their
exposures to the commercial real estate (CRE) markets. As shown in
Chart 4, although CRE concentrations as a percentage of capital have
trended downward for all national banks, they are still significant for
many community banks.
CRE lending is an important product for both small banks and the
communities they serve, but CRE concentrations have played a prominent
role in most of the problem community banks that we supervise. The
timing and effect of the distressed CRE market on individual banks'
overall financial condition has varied by the size, location, and type
of CRE exposure of the bank. For example, rapid deterioration of
construction and development loans led the performance problems in the
CRE sector and thus banks with heavier concentrations in this segment
tended to experience losses at an earlier stage. Performance in this
segment is expected to improve more rapidly as the pool of potentially
distressed construction loans has diminished. Conversely, banks whose
lending is more focused on income-producing commercial mortgages,
including many smaller community banks, are continuing to experience an
increase in problem loans and charge-off rates.
Although commercial property markets across the Nation have begun
to show signs of stabilization, net operating income (NOI), which is
one of the key drivers for CRE property values and the primary source
for loan repayment, continues to decline across most CRE sectors. This
translates to potential for additional losses in income-producing CRE
loans which is a significant issue for community banks since that loan
category is twice as large as the construction and development
portfolios in aggregate.
The OCC has been raising and addressing concerns about the CRE
market and, in particular, the concentrated exposures that many
community banks have to this market, since early 2004 when we initiated
the first of a series of targeted examinations at banks that we
believed were at significant risk due to the nature and scope of their
CRE activities. These supervisory efforts have continued with various
targeted examinations and reviews at national banks with significant
CRE concentrations. Key objectives of our CRE examinations are to
ensure that bank management recognizes and addresses potential problems
at the earliest stage possible--when workout efforts are likely to be
most successful--and that previously identified deficiencies and
shortcomings in risk management practices have been addressed. In this
regard, I want to stress that the OCC has and continues to encourage
bankers to work constructively with borrowers who are facing
difficulties. We firmly believe that prudent CRE loan workouts are
often in the best interest of the financial institution and the
borrower, and it has been our long-standing policy that examiners will
not criticize prudent loan workout arrangements. This does not mean,
however, that examiners will allow bankers to ignore loans with
structural weaknesses or insufficient cash flows to support repayment.
While we encourage bankers to work with troubled borrowers, we also
insist that banks maintain the integrity of their financial reporting
by maintaining appropriate loan loss reserves and capital and, when
warranted, taking appropriate charge-offs.
IV. Challenges Presented for Community Banks by the Post-Crisis
Regulatory Environment
As is commonly observed, the Dodd-Frank Act resulted in the most
comprehensive reform of the United States financial system in decades.
Some of the best-known changes will primarily affect the largest
banking institutions--for example, the new requirements to be imposed
on ``systemically significant'' institutions; the so-called ``Volcker
Rule'' constraints on proprietary trading and investments in hedge
funds and private equity funds; new restrictions on derivatives
activities; and shifting more of the cost of deposit insurance to large
banks. But other requirements within the Act broadly amend banking and
financial laws in ways that affect the entire banking sector, including
community banks.
The challenges banks face have several dimensions: new regulation--
both new restrictions and new compliance costs--on businesses they
conduct, limits on revenues for certain products, and additional
regulators administering both new and existing regulatory requirements.
In the context of community banks, a particular concern will be whether
these combine to create a tipping point causing banks to exit lines of
business that provide important diversification of their business, and
increase their concentration in other activities that raise their
overall risk profile.
For example, the Dodd-Frank Act imposes a range of new requirements
on the retail businesses that are ``bread-and-butter'' for many
community banks. The costs associated with small business lending will
increase when new HMDA-style reporting requirements become effective.
Long-standing advisory and service relationships with municipalities
may cause the bank to be deemed a ``municipal advisor'' subject to
registration with the Securities and Exchange Commission (SEC) and
rules issued by the SEC and the Municipal Securities Rulemaking Board.
And checking account relationships with customers are likely to be
reshaped to recover the costs associated with providing debit cards if
debit interchange fees are restricted.
The new Consumer Financial Protection Bureau (CFPB) is charged with
implementing new requirements that will affect banks of all sizes.
These include new standards for mortgage loan originators; minimum
standards for mortgages themselves; limits on charges for mortgage
prepayments; new disclosure requirements required at mortgage
origination and in monthly statements; a new regime of standards and
oversight for appraisers; and a significant expansion of the current
HMDA requirements for mortgage lenders to report and publicly disclose
detailed information about mortgage loans they originate (13 new data
elements).
The CFPB is also authorized to issue new regulations on a broad
range of topics, including, but not limited to:
additional disclosure requirements to ``ensure that the
features of any consumer financial product or service, both
initially and over the life of the product, are fully,
accurately, and effectively disclosed to consumers in a manner
that permits consumers to understand the costs, benefits, and
risks associated with the product or service, in light of the
facts and circumstances'';
new regulations regarding unfair, deceptive, or ``abusive''
practices; and
standards for providing consumers with electronic access to
information (retrievable in the ordinary course of the
institution's business) about their accounts and transactions
with the institution.
While we strongly support clearer, more meaningful, and accessible
consumer disclosures, it is important to recognize that the fixed costs
associated with changing marketing and other product-related materials
will have a proportionately larger impact on community banks due to
their smaller revenue base. The ultimate cost to community banks will
depend on how the CFPB implements its new mandate and the extent to
which it exercises its exemptive authority for community banks.
Community banks also may be particularly impacted by the Dodd-Frank
Act's directive that Federal agencies modify their regulations to
remove references to credit ratings as standards for determining
creditworthiness. This requirement impacts standards in the capital
regulations that are applicable to all banks. National banks are also
affected because ratings are used in other places in the OCC's
regulations, such as standards for permissible investment securities.
As a result, institutions will be required to do more independent
analysis in categorizing assets for the purpose of determining
applicable capital requirements and whether debt securities are
permissible investments--a requirement that will tax especially the
more limited resources of community institutions.
The Dodd-Frank Act restrictions on corporate governance apply to
community banks as well as larger institutions. Banks that are public
companies will be subject to several new requirements on compensation,
including shareholder ``say on pay'' votes, disclosures on performance-
based compensation arrangements, and compensation clawbacks for
accounting restatements.
Regardless of how well community banks adapt to Dodd-Frank Act
reforms in the long-term, in the near- to medium-term these new
requirements will raise costs and possibly reduce revenue for community
institutions. The immediate effects will be different for different
banks, depending on their current mix of activities, so it is not
possible to quantify those impacts with accuracy. In the longer term,
we expect to see banks adjust their business models in a variety of
ways. Some will exit businesses where they find that associated
regulatory costs are simply too high to sustain profitability, or they
will decide how much of the added costs can, or should, be passed along
to customers. Others will focus on providing products and services to
the least risky customers as a way to manage their regulatory costs.
Some will elect to concentrate more heavily in niche businesses that
increase revenues but also heighten their risk profile. While we know
there will be a process of adaptation, we cannot predict how these
choices will affect either individual institutions or the future
profile of community banking at this stage.
V. Conclusion
Community banks play a critical role in providing financial
services to our Nation's communities and businesses. The OCC is
committed to providing balanced and fair supervision of nationally
chartered community banks and the Federal savings associations that we
assume responsibility for in July.
We are mindful of the economic challenges, and the regulatory and
compliance burdens facing community banks, and that implementation of
the Dodd-Frank Act may accentuate these challenges. It is our goal to
implement the Dodd-Frank Act in a manner that accomplishes the
legislative intent without unduly harming the ability of community
banks to fulfill their role of supporting local economies and providing
the services that their customers rely on. It will be extremely
important that we hear from community banks during the notice and
comment process of our rulemaking efforts to help determine whether we
achieved this goal and whether additional changes or alternatives could
be considered to lessen the burden on community banks.
______
PREPARED STATEMENT OF JOHN P. DUCREST
Commissioner, Louisiana Office of Financial Institutions, and Chairman,
Conference of State Bank Supervisors
April 6, 2011
Introduction
Good afternoon, Chairman Brown, Ranking Member Corker, and
distinguished Members of the Subcommittee. My name is John Ducrest, and
I serve as the Commissioner of Financial Institutions for the State of
Louisiana. I am also the Chairman of the Conference of State Bank
Supervisors (CSBS). It is my pleasure to testify before you today on
behalf of CSBS.
CSBS is the nationwide organization of banking regulators from all
50 States, the District of Columbia, Guam, Puerto Rico, and the Virgin
Islands. State banking regulators supervise, in cooperation with the
Federal Deposit Insurance Corporation and Federal Reserve, over 5,600
State-chartered insured depositories. Further, the majority of State
banking departments also regulate a variety of nonbank financial
services providers, including mortgage lenders. For more than a
century, CSBS has given State supervisors a national forum to
coordinate supervision of their regulated entities and to develop
regulatory policy. CSBS also provides training to State banking and
financial regulators and represents its members before Congress and the
Federal financial regulatory agencies.
Today's hearing comes at a critical time for the community banking
system. Community banks are currently operating in a very challenging
business and regulatory environment. I thank you, Chairman Brown, and
the Members of the Subcommittee for holding such a timely hearing.
Understanding the current challenges and opportunities facing community
banks is an important part of understanding the overall health of the
economy. Even more importantly, the subject of today's hearing
logically leads us to significant questions about the longer-term
prospects for the community banking business model.
In my testimony I will discuss my perspectives as a State banking
regulator on the critical role community banks play in economic
development, job creation, and market stabilization. I will also
address the current regulatory environment in which they operate.
Additionally, my testimony will identify concerns that my State banking
commissioner colleagues and I have about the impact of regulations and
policies on community banks. Finally, I will provide some
recommendations aimed at strengthening the community banking system.
Why Community Banking Still Matters
Over the past several months, my fellow State regulators and I have
heard the very loud concerns of community bankers regarding their
future. These concerns come from the feared trickle-down effect of the
Dodd-Frank Wall Street Reform and Consumer Protection Act and other
regulatory actions deemed necessary to address identified weaknesses in
the banking system. This will undoubtedly add to the compliance burden
being shouldered by the industry. While consumer compliance is
significant, in this context, compliance also includes bank secrecy,
corporate governance, accounting rules, and reporting requirements. In
addition, community banks are facing an uncertain future as the
structure and role of larger institutions in the economy is evolving
and the future of mortgage finance is being debated.
We believe these concerns are very real and are worthy of our
collective attention. This should be a serious, national concern. In
our view, the viability of the community bank model has significant
systemic consequences, which if left unaddressed will cause irreparable
harm to local economies and erode critical underpinnings of the broader
economy.
The challenges the community banking system is facing are already
having an impact upon local economic development, as some local
economies remain stalled or even eroded by more limited credit
availability. As you meet with bankers in your office and in your
State, I encourage you to ask them about the loans which are not being
made. While some banks are not positioned to lend due to their
financial condition, many banks are not making residential real estate
loans due to the increased compliance burden. In addition, commercial
real estate (CRE) loans are not being made due to the stigma of an
entire asset class. We cannot accept this as collateral damage in the
interest of consistency and national policy.
Small Business Lending
The vital role small businesses play in the national economy is
widely recognized. Small businesses are often considered the ``engine''
of the U.S. economy and drive employment across the Nation. Small
firms:
Represent 99.7 percent of all employer firms in the United
States;
Employ half of all private sector employees;
Pay 44 percent of total U.S. private payroll;
Generated 65 percent of net new jobs over the past 17
years;
Made up 97.5 percent of all identified exporters and
produced 31 percent of export value in FY2008; and
Produce 13 times more patents per employee than large
patenting firms. \1\
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\1\ U.S. Small Business Administration, Advocacy Small Business
Statistics and Research, Frequently Asked Questions, http://
web.sba.gov/faqs/faqindex.cfm?areaID=24.
Just as small businesses are recognized as critical to the health
of our national economy, the U.S. banking system remains the most
important supplier of credit to small businesses in the country. While
the volumes are large, banks with over $50 billion in assets allocate
only 24 percent of their loan portfolios to small business loans. Banks
with less than $10 billion in assets invest 48 percent of their loans
in small business (See, Exhibit 1). There is a very significant
difference in the type of small business lending conducted by the
smaller banks. In general, lack of extensive financial data for smaller
firms makes it more difficult for lenders to ascertain if a small
business is ``creditworthy.'' This makes community banks particularly
well suited for small business lending. The largest banks tend to rely
upon transactional banking, in which hard, quantifiable information
drives performance and products are highly standardized. Community
banks, however, engage in relationship banking, involving the use of
soft information which is not readily available or quantifiable.
Synthesis of soft information requires more human input, usually
acquired by direct exchanges between the lender and the borrower, and
relies upon lenders empowered with decision-making authority. \2\ These
types of loans are economically significant at the local level,
providing jobs and economic activity. Collectively, they are
significant for the national economy as well.
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\2\ Hein, Scott E., Timothy W. Koch, and S. Scott MacDonald, ``On
the Uniqueness of Community Banks'', Economic Review (First Quarter,
2005).
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Maintaining the Availability of Credit
In addition to providing critical financial support to small
businesses, community banks have also proven a reliable source of
credit for individuals in smaller communities. The Nation's largest
institutions have a tremendous presence in metropolitan areas, but may
not provide services to residents of small or rural areas (See, Exhibit
2). Community banks, with their geographically focused service areas,
provide the necessary financial products and access to credit for
residents of rural and smaller communities. While community banks are
essential to the very existence of some communities, I would highlight
that the value of the relationship lending model provides needed
services and credit to businesses and consumers in communities of all
sizes.
Through strong and weak economic conditions and in times of crisis,
community banks provide much-needed stability to the financial system
by continuing to make credit and financial services available to
individuals and small businesses. For example, during the crisis in the
capital markets, the Nation's largest banks all but ceased all lending
activity to preserve capital to remain solvent. Community banks,
however, continued to make credit available to individuals and
businesses and helped prevent a complete collapse of the U.S. economy.
In my home State of Louisiana, we have experienced firsthand the
role that community banks play in providing economic stability during
times of crisis. In the wake of Hurricane Katrina, community banks were
the leaders in reopening their doors in the affected areas of the
State. Specifically, locally based institutions quickly reopened at
alternative locations in order to restore and reinforce public
confidence in the State's banking system, provided valuable information
about conditions in the affected areas, and provided much needed
assistance through their lending activities to the rebuilding efforts
in the affected areas. My department worked with our regulated
depository institutions to assist the evacuees in their greatest time
of need, by encouraging these institutions to institute extraordinary
measures, such as: waiving fees for customers and noncustomers seeking
traditional banking services; increasing credit limits, ATM and debit
card withdrawal limits and lines of credit limits for customers;
extending repayment terms on loans, easing credit extension terms for
new loans, and restructuring existing debt; and working with other
institutions to pool resources in order to provide cash, the most
essential item in the immediate aftermath of Hurricane Katrina. In
general, the financial services industry reacted quickly and
aggressively to work with their customers in any way possible to
restore the availability of credit and cash in the affected areas of
Louisiana.
Diversity
The recent financial crisis has reminded us all of the necessity of
having a strong, stable and diverse banking industry in the United
States. A diverse banking industry characterized by banks of varying
sizes, complexities, specialties, and locations ensures consumers have
access to credit and banking services in every corner of the country
and around the globe and through every part of the business cycle.
Despite the recent collapse of the capital markets and the ensuing
recession, the United States still boasts approximately 7,600 insured
depository institutions, ranging in size from $1.3 million to over $1.6
trillion in assets.
The past few decades, however, have been marked by a decrease in
the total number of insured financial institutions and stunning
consolidation of the industry's assets into the largest institutions.
In the last 25 years, we have lost 12,362 banks. This represents 62
percent of the total as of December 31, 1985 (See, Exhibit 3). While a
significant portion of consolidation may be market driven, we do not
believe all of the drivers and long-term impact of consolidation are
fully understood. As the industry consolidates, the system is
increasingly dominated by the largest institutions. In the last 10
years, the top 5 banks have increased their market share from 24
percent to 42 percent of total assets. This industry consolidation
raises concerns because of the critical role many smaller institutions
play in the communities and States in which they operate.
To ensure a diverse industry, the community banking system must be
able to thrive alongside of, and compete with, other banks, regardless
of size. A generally agreed upon, but rapidly approaching outdated,
definition of a community bank is an insured depository institution
with $1 billion or less in assets. Perhaps a better definition is an
institution with a local focus and scope of activities, with the
corresponding experience and expertise to excel at relationship
lending. A community bank is to a local business what Wall Street is to
a Fortune 50 company: not just a lender, but a financial and business
adviser.
A strong community banking system is absolutely critical to the
well-being of the United States economy. As discussed above, a diverse
financial system characterized by strong community banks ensures local
economic development and job creation, provides necessary capital for
small businesses, and provides stability and continued access to credit
during times of crisis. Therefore, it is critical that policies and
decisions made in Washington, DC, carefully consider the impact on
smaller banks and the communities they serve. Put simply, how community
banks are impacted by Dodd-Frank and other regulatory measures is too
important not to understand.
The Current Environment for Community Banks
Despite indicators that the national economy and some of the
Nation's largest financial institutions are showing signs of
improvement, community banks continue to operate--or in too many cases,
struggle to survive--in a very challenging environment. The Nation's
biggest banks have returned to profitability faster than smaller banks.
As of the 4th quarter of 2010:
Only 12.15 percent of banks over $10 billion in assets
remain unprofitable.
In contrast, 21 percent of institutions under $1 billion in
assets remain unprofitable.
During the collapse of the capital markets, the Nation's largest
institutions were granted unprecedented and extraordinary Government
assistance through a variety of programs and policies to not only
remain solvent but to facilitate a return to economic health. Community
banks have not received the same extraordinary assistance, and have
been operating under an economic recession largely not of their making.
In addition, the regulatory environment for community banks has proven
unforgiving for miscalculations of risk. Since the start of the crisis
in 2008, 348 banks have failed. The overwhelming majority of these
banks have been community banks. Most of these failed institutions have
been acquired by other community banks, while banks with assets greater
than $100 billion have bought only 7 percent of the failed banks. While
failures are disruptive at the local level, it is important to note
that the regulatory and resolution process for this part of the
industry worked. The community banking system is healing itself. We
must ensure there is a structure and policies in place which encourage
the active participation of community banks in the market. In my State
and in my communities, I see needs that will not be met by the biggest
institutions. Therefore, we must create an environment that does not
drive people and capital away and attracts new entrants to the market.
Increasingly, I am hearing a desire from community bankers to merge or
sell their institution because they are overwhelmed by regulatory
burden and the perception of a Federal system which no longer supports
their business model. The model of other concentrated banking systems,
like Japan, where collapse was followed by long-term stagnation, should
be better understood before we continue down the perhaps irreversible
road of further consolidation.
CSBS appreciates that the Dodd-Frank Act was drafted with an eye to
preserving the community banking system. CSBS views the Dodd-Frank Act
as a reaffirmation of the importance of the dual-banking system and all
that it entails: a system of regulatory checks and balances that serves
as a counterweight to consolidation both of regulatory authority in
Washington, DC, and of influence into a handful of money-center banks;
a diverse and competitive industry marked by charter choice and
innovation; and access to credit for individuals and businesses in
every corner of the country. However, we also understand that
uncertainty about the impact of Dodd-Frank, especially when combined
with a challenging business environment and general concerns about the
direction of regulation, could create a sense of a crushing regulatory
environment.
CSBS believes that community bank-oriented Dodd-Frank provisions
such as the change in the deposit insurance assessment base which
favors smaller, less-risky community banks and the elevation of deposit
insurance coverage to $250,000 for individual accounts are critical for
community banks. Additionally, the coordination that Dodd-Frank
requires among State and Federal regulators, such as the newly created
Consumer Financial Protection Bureau (CFPB) and the Financial Stability
Oversight Council (FSOC), serve the important goals of improving
regulation efficiently and giving voice to a community bank regulatory
perspective. Earlier this year, the CFPB signed its first information-
sharing memorandum of understanding with CSBS and several State banking
departments, a positive indicator that the CFPB intends to leverage the
work of State regulators in protecting consumers and in bringing
efficient compliance supervision to the community banking system.
Finally, CSBS appreciates the bill attempts to address the problems
created by providing explicit Government guarantees for a cadre of
megabanks considered ``too big to fail.'' Addressing--and hopefully
eliminating--the competitive advantages created by the perception and
reality of being ``too big to fail'' has direct consequences for
community banks. However, whether, and to what extent ``too big to
fail'' has truly been rectified remains unclear. From the standpoint of
State banking regulators, evaluating the success of efforts to
eliminate ``too big to fail'' means looking at:
Whether the cost of funds for institutions becomes more
competitive, regardless of the institution's size. Currently,
megabanks enjoy a significant advantage in this area and are
able to obtain funds at a much more affordable rate than
community banks, giving them a clear operational advantage to
the majority of the Nation's banks. As demonstrated by Fannie
Mae and Freddie Mac, a funding advantage and perceived Federal
guarantee can translate into market dominance.
The efficacy of Dodd-Frank's resolution regime for large
complex financial institutions. In a properly functioning,
market-driven industry, bank resolutions must be allowed to
occur when an institution becomes insolvent. Dodd-Frank did put
a resolution regime in place, but until an institution that was
once considered ``too big to fail'' is resolved in an orderly
manner, such a regime will remain an empty threat to the
biggest banks, and more importantly their investors and
creditors, as they operate without fear of consequences for
risky actions.
Whether the banking industry in the United States remains
diverse, with institutions of all sizes operating in
communities around the Nation by regular chartering of de novo
institutions to fully serve the dynamic U.S. economy.
Application of the Dodd-Frank concentration limit. This
concentration limit, if implemented successfully, will do much
to prevent banks from becoming ``too big to fail'' and will
help ensure a competitive industry.
Whether the ratings agencies consider being systemic or too
big to fail a sign of strength and safety and a reason for a
higher rating.
Whether the cost of being systemic must be real and
encourage an overall reduction in risk to the economy.
Regulatory policy should clearly dissuade institutions from
becoming too big to fail.
The Dodd-Frank Act was a sweeping overhaul of financial regulation
and will require significant commitment, time and resources to fully
implement. As a result, we are still unaware of the full scope of the
impact of Dodd-Frank will have upon the industry as a whole, and
community banks specifically. For example, we share our Federal
counterparts' concerns about the impact of the interchange fee
provision could have upon community banks. As we discussed in a comment
letter to the Federal Reserve Board, we do not fully understand the
full impact this provision could have. In the near-term, given the
condition of the industry, we fear near-term negative consequences for
earnings and further impediments to the long term viability of the
community banking model (See, Exhibit 4).
The financial crisis and recession exposed weaknesses in risk
management and supervisory practices which need to be addressed. These
include:
Concentrations;
Loan underwriting;
Funding sources, such as brokered deposits and wholesale
funding;
Capital standards; and
Standards and expectations for de novo institutions.
Unfortunately, the potential solutions to these issues only
increase the concern of community bankers. A broad brush approach,
bright line limitations, and a checklist of risk management
requirements will surely over-tax the industry. We need to ensure that
regulatory policy in these areas does not further undermine the very
industry it is attempting to strengthen. FDIC Chairman Bair's recent
comments about community banks and CRE lending reflect this sentiment:
I believe that supervisory policies need to reflect the reality
that most community banks are specialty CRE lenders and that
examiners need to focus on assuring quality underwriting
standards and effective management of those concentrations.
Though hundreds of small banks have become troubled or failed
because of CRE concentrations, thousands more have successfully
managed those portfolios. We need to learn from the success
stories and promote broader adoption of proven risk-management
tools for banks concentrated in CRE. \3\
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\3\ Remarks by FDIC Chairman Sheila C. Bair to the ICBA National
Convention, San Diego, California, March 22, 2011, http://www.fdic.gov/
news/news/speeches/chairman/spmar2211.html.
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Recommendations To Address Concerns and Preserve Community Banking
System
The economic crisis, the resulting recession, and now enhanced
regulatory burden have combined to create an incredibly challenging
operating environment for community banks. More consideration must be
made by policy makers to understand the long-term impact our decisions
and actions have upon the community banking system. To that end, I have
a few suggestions for implementing a revamped regulatory regime while
still encouraging the success of the community banking system.
First, there must be continued coordination and consultation
between Federal and State regulators to best understand how local and
national economies will be impacted by new regulations. I believe the
most effective system of financial supervision is one characterized by
both State and Federal financial regulation, what my colleague from New
York, Superintendent of Banks Richard Neiman, refers to as
``cooperative federalism.'' A system of supervision based on
cooperative federalism allows for comprehensive, effective and
efficient supervision of the banking industry. Key components of a
State/Federal supervisory system are the proximity of State regulators
to the entities we supervise, and our ability to identify emerging
threats or trends in the banking industry, as well as the ability of
Federal regulators to implement regulations on a national scale and
applicable to all market participants.
Second, more analysis is needed to fully understand and appreciate
the valuable relationship between community banks and small business.
My fellow State regulators and I know anecdotally that the community
banking system is at peril, and therefore the small business sector in
the United States is also in jeopardy. However, the lack of data and
analysis in this area has failed to provide a clear enough
understanding to appreciate industry diversity and a viable and
competitive community banking system. Significant resources at the
Federal level exist to perform such analysis and would provide
tremendous benefit to the national economy, but also to your State and
local economies. Across the country, different communities benefit from
unique community banks that are specifically tailored to meet their
needs. Gathering data to better understand and appreciate the business
models of community banks will provide greater appreciation for this
significant issue on a greater scale and will provide clear
justification for a national priority to ensure public policy enables
and does not overly burden community banking.
Finally, CSBS recommends that Congress and the Federal regulators
investigate ways to tailor regulatory requirements to institutions
based upon their size, complexity, geographic location, management
structure, and lines of business. The current ``one size fits all''
approach to regulation, both in terms of safety and soundness and
compliance supervision, has fallen harder on community banks and driven
dramatic consolidation and bifurcation of the banking industry. Perhaps
it is time to explore a bifurcated system of supervision. After all, a
bank with a single branch in one State has a dramatically different
business model than Bank of America or Citigroup, so it should not be
held accountable to the same supervisory structure as institutions
which employ thousands of people and operate in hundreds of nations.
Conclusion
As I mentioned at the beginning of my testimony, addressing the
challenges facing community banks now is very important and a
meaningful exercise. However, as important as understanding the current
condition of community banking is, an awareness that decisions made and
actions taken today will have a long-term impact on the viability of
the community banking model is critical. After the Nation recovers from
the recession and the provisions of the Dodd-Frank Act are implemented,
what will our banking industry look like? We must ensure industry
diversity and full access to credit across the country by creating an
environment which benefits all institutions, but particularly the
community banks which are so vital to providing stability, access to
credit, and support for the small business sector.
CSBS stands ready to work with Members of Congress and our Federal
counterparts to create a regulatory regime which encourages industry
diversity, creates a level playing field for all institutions, and will
ultimately strengthen the local economies and the U.S. economy.
Thank you for the opportunity to testify today, and I look forward
to answering any questions you may have.
PREPARED STATEMENT OF WILLIAM A. LOVING
President and Chief Executive Officer, Pendleton Community Bank,
Franklin, West Virginia, on behalf of the Independent Community Bankers
of America
April 6, 2011
Chairman Brown, Ranking Member Corker, and Members of the
Subcommittee, my name is William A. Loving, Jr., and I am President and
CEO of Pendleton Community Bank, a $250 million asset bank in Franklin,
West Virginia. I am pleased to be here today to represent the nearly
5,000 members of the Independent Community Bankers of America. Thank
you for convening this hearing on ``The State of Community Banking:
Challenges and Opportunities.''
We appreciate your interest in the community banks of this country,
which will undoubtedly play a significant role in any broad based
economic recovery because we serve rural, small town, and suburban
customers and markets, that are not comprehensively served by large
banks. Our business is based on long-standing relationships in the
communities in which we live. We make loans often passed over by the
large banks because a community banker's personal knowledge of the
community and the borrower gives him firsthand insight into the true
credit quality of a loan, in stark contrast to the statistical model
used by a large bank in another State or region of the country. These
localized credit decisions, made one-by-one by thousands of community
bankers, will restore our economic strength.
Community banks are prodigious small business lenders. We provide
small business credit in good times as well as challenging times--
supporting a sector responsible for more job creation than any other.
In his recent speech before the ICBA annual convention, Federal Reserve
Chairman Ben Bernanke shared new Federal Reserve Bank research that
shows that while overall small business lending contracted during the
recent recession, lending by a majority of small community banks (those
of less than $250 million in assets) actually increased, and small
business lending by banks with asset sizes between $250 million and $1
billion declined only slightly. By contrast, small business lending by
the largest banks dropped off sharply. The viability of community banks
is linked to our small business customers in the communities we serve,
and we don't walk away from them when the economy tightens.
When community banks thrive they create a diverse, competitive
financial services sector offering real choice, including customized
products, to consumers and small businesses alike. An economy dominated
by a small number of large banks wielding undue market power and
offering commodity products would not provide the same level of
competitive pricing and choice. Promoting a vibrant community banking
sector is an important public policy goal.
Community Banks Remain Strong
The past few years have been tumultuous for community banks, but
the vast majority of them are well capitalized and are helping to lead
the economic recovery. Still, community banks were not unaffected by
the financial collapse. The weakened economy has caused many consumers
to tighten their belts and reduced the demand for credit. Despite the
wave of failures and consolidations since the financial crisis, I fully
expect the community bank business model will thrive in the future, to
the benefit of consumers, small business, and the economy. Many ICBA
members have been in business for more than 100 years and have survived
the Great Depression and numerous other recessions. The community
banking sector will remain vibrant, but policy makers must help by
providing relief from overly burdensome regulations.
Oppressive Examination Environment
In addition to contracting demand for credit and impairing asset
quality, the financial crisis harmed community banks by provoking an
overreaction among bank examiners. The most frustrating aspect of this
exam environment is the disconnect between the examiners in the field
and the directives from Washington.
A November 2008, Interagency Statement on Meeting the Needs of
Creditworthy Borrowers established a national policy for banks to
extend credit to creditworthy borrowers in order to help initiate and
sustain an economic recovery. It stated, ``The agencies expect all
banking organizations to fulfill their fundamental role in the economy
as intermediaries of credit to businesses, consumers, and other
creditworthy borrowers.'' Unfortunately, this policy is often neglected
by examiners in the field, especially in the regions most severely
affected by the recession. Field examiners are second guessing bankers
and independent professional appraisers and demanding unreasonably
aggressive write-downs and reclassifications of viable commercial real
estate loans and other assets. The misplaced zeal of these examiners is
having a chilling effect on lending. Good loan opportunities are passed
over for fear of examiner write down and the resulting loss of income
and capital. The contraction in credit is having a direct, adverse
impact on the recovery.
Community Banks Are Disproportionately Impacted by Regulation
Community banks have little in common with Wall Street firms,
megabanks, or shadow banks and did not cause the financial crisis or
engage in abusive consumer practices. Community banks have a much
different risk profile because their business model is built on long-
term customer relationships, and they cannot succeed without a
reputation for fair treatment. For these reasons, ICBA believes it is
appropriate to tier regulation of the financial services industry.
Overly prescriptive regulation would only reduce community banks'
flexibility in serving the unique needs of their customers. Moreover,
regulation has a disproportionate impact on community banks because
they have fewer resources to dedicate to compliance.
We are pleased the Dodd-Frank Act exhibits a clear preference for
tiered regulation of the financial sector--one of the most important
precedents of that legislation. We believe Congress should further
advance this trend by enacting legislation to provide much needed
regulatory relief for community banks, their customers, and their
communities. Such legislation should also reduce the tax burden on
community banks and narrow the competitive gap between tax-paying
community banks and tax-exempt credit unions.
Areas in which ICBA seeks relief include:
Requiring FASB to conduct a cost/benefit analysis for any
proposed accounting change;
Lowering Small Business Administration origination and
program fees for rural and small business borrowers;
Restoring dividend payments on GSE preferred stock;
Increasing the SEC shareholder registration threshold;
Amending the Dodd-Frank Act to restore bank reliance upon
external credit ratings; and
Extending the 5-year net operating loss (NOL) carry back
provision.
The Communities First Act (CFA), a bill meeting the broad
objectives outlined above, was introduced and advanced during the 109th
and 110th Congresses with bi-partisan support. In the 110th Congress,
CFA was introduced in the House by then-Small Business Committee
Chairwoman Nydia Velazquez (D-NY). The Senate version was introduced by
then-Senator Sam Brownback (R-KS).
The 2006 Financial Services Regulatory Relief Act (FSRRA) and other
laws were welcome down payments on needed regulatory and tax relief for
community banks. These laws have included provisions taken from prior
versions of CFA, notably doubling to $500 million the asset size of
banks eligible for the extended 18-month exam cycle. Our communities
would benefit from the further relief provided by similar legislation
in 2011.
The Dodd-Frank Act
The Dodd-Frank Act was generational legislation and will
permanently alter the landscape for financial services. Every provider
of financial services--including every single community bank--will feel
the effects of this new law to some extent. Undeniably, it will result
in additional compliance burden for community banks and will be
challenging for them. The full and ultimate impact won't be known for
years, depending on how the law is implemented and how the market
adjusts to it. There's still an opportunity to improve some negative
provisions in the law--with the help of this Committee and Congress--
and provisions that could be helpful to community banks are still at
risk of being weakened in the implementation.
Debit Interchange
By a wide margin, the most troubling aspect of the Dodd-Frank Act
is the debit interchange, or ``Durbin,'' amendment. Despite the
statutory exemption for institutions with less than $10 billion in
assets, which many Senators thought would help community banks; we
believe small financial institutions cannot be effectively carved out.
Chairman Bernanke, the regulator charged with implementing the new law,
conceded this point in a recent hearing before the Senate Banking
Committee. Visa's announced two-tiered pricing system, however well-
intentioned, also will not work. Small issuers will feel the full
impact of the Durbin amendment over time. It's too easy to focus on the
large issuers and lose sight of the thousands of community bank issuers
who will be harmed if the Federal Reserve proposal is implemented. Not
only are small issuers not carved out in practice, they would be
disadvantaged relative to large issuers, and a likely consequence of
the Federal Reserve's proposed rule, if implemented, is further
industry consolidation, higher fees, and fewer choices for consumers.
Why won't the carve-out work? The reasons are twofold. First, in
addition to the interchange price-fixing provisions of the law and the
Federal Reserve proposal, other less-discussed provisions shift control
of transaction routing from the card issuer to the merchant. These
provisions apply to all financial institutions, regardless of size, and
negate the benefit, if any; small financial institutions would gain
from the interchange price-fixing exemption. Granting retailers the
ability to route debit card transactions over the network of their
choice--the card issuer currently designates the network on which its
card is routed--will allow retailers to bypass the two-tier system.
Further, large retailers will be able to incentivize customers to use
the rate-controlled cards issued by the largest financial institutions,
discriminating against community banks and their customers. Community
bank cards will either be subject to the lower rate or their cards will
be neglected by retailers.
There's a second way in which the carve-out fails to shield small
issuers. In any two-tier system, the small issuer interchange rate, to
the extent that small issuers actually receive it, will surely be lower
than the current interchange rate. The payment card networks will be
under considerable pressure from their clients with more than $10
billion in assets to narrow the gap between the two tiers.
For these reasons, a tiered system will not protect community
banks. Over time, community bank interchange revenue will drop sharply
with a direct impact on community bank customers.
What would happen if the current Federal Reserve proposal were
implemented? ICBA recently completed a survey of its members, and the
results demonstrate that the Federal Reserve proposal would alter the
economics of community banking and fundamentally and adversely change
the nature of the relationship between a community bank and its
customers. Among the survey results: Community banks would be forced to
charge their customers for services currently offered for free and that
customers have come to expect and value--debit cards, checking
accounts, online or mobile banking. Community banks will have
difficulty offering their customers--both consumers and small
businesses--competitive rates on deposits and loans. It will be harder
to qualify for a debit card. Finally, 20 percent of survey respondents
say they will have to eliminate jobs or halt plans to open new bank
branches--extending the impact from individual consumers to
communities. To use my bank as an example, in 2010 we had about 6,250
debit cards outstanding and our profit for the year was approximately
$132,000 pretax. If the Federal Reserve proposal goes into effect, I
estimate that we could lose, based upon the lowest proposed interchange
rate, approximately $237,000 pretax on our debit card program--lost
income that we would have to make up through higher fees on our
products and services.
Our global payments system works so well that thousands of small
community banks are able to stand toe-to-toe and offer services to
consumers in direct competition with banks like Citigroup and Bank of
America, while providing the quality of relationship service only a
community banker can give. The new law and the Federal Reserve proposal
would threaten the ability of community banks to compete with large
issuers and would bring about further industry consolidation, to the
detriment of consumers and small businesses in small town and rural
America.
ICBA is grateful to Senators Tester and Corker for introducing S.
575, the ``Debit Interchange Fee Study Act,'' which would delay
implementation of the Durbin amendment for 2 years.
Mortgage Risk Retention
Community banks make commonsense mortgages supported by sound,
conservative underwriting. As the banking regulatory agencies implement
Section 941 of the Dodd-Frank Act, which requires mortgage originators
to retain credit risk on nonqualified residential mortgages, ICBA
strongly urges them not to define ``qualified residential mortgage,''
or QRM, too narrowly. An unreasonably narrow definition of QRM will
drive thousands of community banks from the residential mortgage
market, leaving it to only a few of the largest lenders. Too narrow a
definition will also severely limit credit availability to many
borrowers who are creditworthy though unable to make significant down
payments. In ICBA's view, the definition of QRM should be relatively
broad and encompass the largest portion of the residential mortgage
market, consistent with the stronger underwriting standards called for
by the Act. An unduly narrow definition of QRM will disadvantage
community banks because they lack access to the increased capital
needed to offset risk retention requirements, despite conservative
underwriting. What's more, community banks operating in rural areas
will be driven out of the market by Farm Credit System direct lenders
who carry an exemption for the loans or other financial assets that
they make, insure, guarantee or purchase.
We are currently reviewing the proposed rule released last week,
which is over 300 pages and raises scores of questions. While I am sure
we will offer many suggested changes, overall, for the community
banking industry, there are many positive provisions in the proposal,
notably, the exemption from the QRM standards and risk retention
requirements for loans sold to Fannie Mae and Freddie Mac, as long as
they have Government capital. Because the vast majority of residential
mortgages originated by community banks are conforming loans sold to
Fannie Mae and Freddie Mac, the proposal would preserve the ability of
community banks to continue to provide their customers with long-term
mortgages. ICBA is also pleased that the proposed rule does not impact
mortgage loans held in portfolio and focuses the risk retention
requirement on securitizers, not originators.
Consumer Financial Protection Bureau
While we are pleased the Dodd-Frank Act allows community banks with
less than $10 billion in assets to continue to be examined by their
primary regulators, ICBA remains concerned about CFPB regulations, to
which community banks will be subject. ICBA strongly opposed provisions
in the Dodd-Frank Act that excluded the prudential banking regulators
from the CFPB rule-writing process. Bank regulators are in the best
position to balance the safety and soundness of banking operation with
the need to protect consumers from unfair and harmful practices and
provide them with the information they need to make informed financial
decisions.
The Act gives the prudential regulators the ability to comment on
CFPB proposals before they are released for comment and an extremely
limited ability to veto regulations before they become final. This veto
can only be exercised if, by a 2/3 vote, FSOC determines that a rule
``puts at risk safety and soundness of the banking system or the
stability of the financial system,'' an unreasonably high standard and
one that should be amended. ICBA supports changing the standard so the
FSOC is permitted to veto a CFPB rule that could adversely impact a
subset of the industry in a disproportionate way. We believe this
standard would give prudential regulators a more meaningful role in
CFPB rule writing.
Absent such legislation, ICBA encourages the CFPB to reach out to
community banks as they contemplate rules--before proposed rules are
issued--to better understand how proposed rules would impact community
bank operations and community bank customers. In particular, any rules
that privilege ``plain vanilla'' products (credit cards, mortgages,
etc.) would adversely impact community banks, who are frequently the
only providers who are willing to customize products to meet customer
needs.
Any enhanced consumer protection laws should focus on the
``shadow'' financial industry which has been most responsible for
victimizing consumers while avoiding serious regulatory scrutiny. This
segment of the financial services industry should be brought under the
same regulatory and supervisory umbrella as commercial banks. ICBA
supports a balanced regulatory system in which all financial firms that
grant credit are subject to meaningful supervision and examination.
Under Dodd-Frank, the CFPB has discretion in defining nondepository
``covered persons'' subject to CFPB rules, examination and enforcement.
ICBA urges the CFPB to broadly define ``covered persons.''
Community banks are already required to spend significant resources
complying with voluminous consumer protection statutes. CFPB rules
should not add to these costs. The Dodd-Frank Act gives the CFPB
authority to exempt any class of providers or any products or services
from the rules it writes considering the size of the entity, the volume
of its transactions and the extent to which existing law already has
protections.
ICBA urges the CFPB to use this authority to grant broad relief to
community banks and/or community bank products where appropriate.
The Dodd-Frank Act is a mixed outcome for community banks. I've
noted some of our concerns, but the legislation also gave us an
opportunity to advance long sought priorities.
Too-Big-To-Fail
ICBA has long expressed concerns about too-big-to-fail banks and
the moral hazard they pose, well before the financial crisis. Community
banks are more finely tuned to these concerns because we and our
customers feel the direct impact. It's challenging for us to compete
against megabanks whose too-big-to-fail status gives them funding
advantages. For this reason, we're pleased the Act takes steps to
mitigate too-big-to-fail.
ICBA supported the creation of the Financial Stability Oversight
Council (FSOC) whose duties include identifying and responding to risks
to financial stability that could arise from the failure of a large,
interconnected bank or nonbank. We are pleased that Dodd-Frank provides
for enhanced prudential standards for systemically risky firms,
including higher capital, leverage, and liquidity standards,
concentration limits and contingent resolution plans. Firms subject to
these higher standards should include, but not necessarily be limited
to, large investment banks, insurance companies, hedge funds, private
equity funds, venture capital firms, mutual funds (particularly money
market mutual funds), industrial loan companies, special purpose
vehicles, and nonbank mortgage origination companies.
We also support the FDIC's new resolution authority to empower it
to unwind large, systemically risky financial firms. The Government
must never again be forced to choose between propping up a failing firm
at taxpayer expense and allowing it to fail and wreak havoc on the
financial system. Powerful interest groups are lobbying doggedly to
undermine the too-big-to-fail provisions of Dodd-Frank, which are
essential to creating a robust and competitive financial services
sector to the benefit of consumers, businesses, and the economy. We
urge this committee to ensure that these provisions are upheld and
enforced.
Deposit Insurance
ICBA was a leading advocate for the deposit insurance provisions of
the Act, including the change in the assessment base from domestic
deposits to assets (minus tangible equity), which will better align
premiums with a depository's true risk to the financial system and will
save community banks $4.5 billion over the next 3 years. The deposit
insurance limit increase to $250,000 per depositor and the 2-year
extension of the Transaction Account Guarantee (TAG) Program, which
provides unlimited deposit insurance coverage for non- interest-bearing
transaction accounts, will help to offset the advantage enjoyed by the
too-big-to-fail megabanks in attracting deposits.
Small Business Lending Fund
ICBA fully supports the $30 billion Small Business Lending Fund
(SBLF) program. This program will provide capital for interested
community banks to increase small business lending in their communities
and boost economic growth. With the private capital markets for small
and midsized banks still largely frozen since the financial crisis,
SBLF provides an important alternative source of capital for interested
healthy banks, structured to incentivize increased lending. We urge
Treasury to complete the term sheets for Subchapter S and Mutual banks
so they too can have access to tier 1 SBLF capital as Congress
intended.
Closing
Thank you again for your interest in and commitment to community
banks and for the opportunity to testify today. I've outlined some of
the more significant regulatory challenges we face in the months ahead.
Negotiating these challenges will help us to serve our communities and
promote the economic recovery--a goal we share with this Committee.
Thank you for hearing our concerns. We look forward to working with
you.
______
PREPARED STATEMENT OF TOMMY G. WHITTAKER
President and Chief Executive Officer, The Farmers Bank, Portland,
Tennessee, on behalf of the American Bankers Association
April 6, 2011
Chairman Brown, Ranking Member Corker, and Members of the
Subcommittee, my name is Tommy Whittaker, President and Chief Executive
Officer, The Farmers Bank, Portland, Tennessee. The Farmers Bank was
chartered in 1912 and is a $560 million institution with 11 offices and
152 employees. We serve Robertson and Sumner Counties in northern
middle Tennessee, with a population of approximately 130,000 people. I
appreciate the opportunity to present the views of the ABA on the state
of community banking and the challenges and opportunities that we face.
The ABA represents banks of all sizes and charters and is the voice of
the Nation's $13 trillion banking industry and its two million
employees.
At my bank, as is true of my banker colleagues around the country,
we are intensely focused on building and maintaining long-term
relationships with our customers. It is because of these relationships
The Farmers Bank will be celebrating a century of service to our
customers and community in 2012. We cannot be successful without such a
long-term philosophy and without treating our customers fairly.
We are proud to say we have been in business for almost 100 years,
but our long tradition of service is not unique among banks. In fact,
there are 2,735 banks--35 percent of the banking industry--that have
been in business for more than a century; 4,937 banks--64 percent--have
served their local communities for more than half a century. These
numbers tell a dramatic story about the staying power of banks and
their commitment to the communities they serve.
The success of The Farmers Bank is inextricably linked to the
success of the communities we serve, and we are very proud of our
relationships with them. They are, after all, our friends and
neighbors.
Let me give you just a glimpse of The Farmers Bank's close ties
with our communities. We have $348 million in loans on our books.
Included in that number are approximately 175 loans, totaling $3.8
million to our farmers for agricultural operations, 750 loans, totaling
$29.2 million to our local businesses for their commercial and business
needs, 633 loans, totaling $191.2 million to developers for commercial
construction projects and farmers for purchase of farm land, and 1,765
loan, totaling $116 million for the construction and financing of 1 to
4 family homes. In addition, we have $4 million in loans to our local
municipalities that help them fund improvements to services to their
cities.
Not only do we provide the funding to meet the credit needs for our
communities, our people are truly a part of these communities. For
example, each year our bank participates in the ABA's National Teach
Children To Save Day. In 2010, we had 26 employees volunteer their time
in fifteen area schools. We had another 22 employees involved in
community organizations, such as The Chamber of Commerce, Lions Club,
Rotary Club, and numerous other Civic Clubs. Moreover, in the last 2
years, our bank has donated over $112,000 for scholarships, community
events, and other local projects.
When a bank sets down roots, communities thrive. A bank's presence
is a symbol of hope, a vote of confidence in a town's future. The
health of the banking industry and the economic strength of the
Nation's communities are closely interwoven. We strongly believe that
our communities cannot reach their full potential without the local
presence of a bank--a bank that understands the financial and credit
needs of its citizens, businesses, and Government. I am deeply
concerned that this model will collapse under the massive weight of new
rules and regulations. The vast majority of banks never made an exotic
mortgage loan or took on excessive risks. They had nothing to do with
the events that led to the financial crisis and are as much victims of
the devastation as the rest of the economy. We are the survivors of the
problems, yet we are the ones that pay the price for the mess that
others created.
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
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.
Managing this mountain of regulation will be a significant
challenge for a bank of any size. The median-sized bank has only 37
employees--for them, and for banks like mine, this burden will be
overwhelming. Historically, the cost of regulatory compliance as a
share of operating expenses is two and a half times greater for small
banks than for large banks. Moreover, it creates more pressure to hire
additional compliance staff, not customer-facing staff. It means more
money spent on outside lawyers to manage the risk of compliance errors
and greater risk of litigation. It means more money to hire consulting
firms to assist with the implementation of all of the changes, and more
money hiring outside auditors to make sure there are no compliance
errors. It means more risk of regulatory scrutiny, which can include
penalties and fines. All of these expenditures take away precious
resources that could be better used serving the bank's community.
The consequences are real. Costs are rising, access to capital is
limited, and revenue sources have been severely cut. It means that
fewer loans get made. It means a weaker economy. It means slower job
growth. With the regulatory over-reaction, piles of new laws, and
uncertainty about Government's role in the day-to-day business of
banking, meeting local community needs is difficult at best.
Without quick and bold action to relieve regulatory burden we will
witness an appalling contraction of the banking industry, with a
thousand banks or more disappearing from communities all across the
Nation over the next few years. These are good banks that for decades
have been contributing to the economic growth and vitality of their
towns, cities, and counties but whose financial condition is being
undermined by excessive regulation and Government micro-management.
Each bank that disappears from the community makes that community
poorer.
Congress must be vigilant in overseeing regulatory actions that
unnecessarily restrict loans to creditworthy borrowers. Holding
oversight hearings like this one is critical to ensure that banks are
allowed to do what they do best--namely, meet the credit needs of their
communities.
In my testimony today, I'd like to focus on three key themes:
New rules substitute Washington bureaucratic judgment for
that of local bankers
Increasingly, the Government has inserted itself in the
day-to-day business of banking. The Government should not be in
the business of micro-managing private industry. Traditional
banks tailor products to borrowers' needs in local communities,
and prescriptive rules inevitably translate into less access to
credit and banking services.
The most egregious example is the price-controls on
interchange fees resulting from the Federal Reserve's
implementation of the Durbin Amendment in the Dodd-Frank Act.
Such actions will have significant unintended consequences. The
legislation introduced by Senators Tester and Corker--S. 575--
rightly recognizes that the Federal Reserve's rule will cause
significant and immediate harm to community banks, consumers
and the broader economy. The ABA strongly supports S. 575 and
urges fast action to adopt this important legislation.
New laws end up punishing community banks that had nothing
to do with the crisis
Each change in law adds another layer of complexity and
cost of doing business. Dodd-Frank rules threaten to drive
community banks out of lines of business altogether,
particularly mortgage lending and services to municipalities.
It has also stimulated an environment of uncertainty and added
new risks that will inevitably translate into fewer community
financial services.
The consequences for consumers and the economy are severe
The Dodd-Frank Act will raise costs, reduce income, and
limit potential growth, all of which drives capital away from
banking, restricts access to credit for individuals and
business, reduces financial resources that create new jobs, and
retards growth in the economy.
I will discuss each of these in detail in the remainder of my
testimony.
I. Individual Rules Substitute Washington Bureaucratic Judgment for
That of Bankers in Local Communities
Increasingly, the Government has inserted itself in the day-to-day
business of banking. Micro-managing private industry should not be the
role of Government. Inevitably it leads to negative unintended
consequences.
The most egregious example is the price-controls for interchange
fees being promulgated by the Federal Reserve under the Durbin
Amendment. The result devastates retail bank profitability, stifles
innovation, lowers productivity in our economy and forces a number of
individuals out of the protection of the banking system.
The price-controls proposed by the Federal Reserve in the
implementing rule will reduce interchange income by as much as 85
percent. Some will say that the so-called ``carve-out'' from the
Federal Reserve's rule under Dodd-Frank for community banks (under $10
billion in assets) will protect community bank earnings. Nothing could
be further from the truth. Having two different prices for the exact
same product is not sustainable. The price cap proposed by the Federal
Reserve is so severe that it creates enormous economic incentives for
retailers to adopt strategies to favor the cards with lower interchange
rates. Market share will always flow to the lowest priced product, even
if those lower prices are mandated only for some. The result for small
banks is either a loss of market share, loss of revenue that supports
free checking and other valuable services, or both.
Revenue from interchange in many cases does not cover the cost of
providing debit card services. With the Federal Reserve's proposal,
debit cards would be completely unprofitable. In fact, the proposed
rule dictates that banks must lose money on every debit card
transaction we process unless we charge consumers more. It makes no
sense to force any provider of any service to offer products below the
cost of producing them. I cannot offer financial services if I cannot
cover the costs of doing so and provide a reasonable return to my
shareholders.
Consumers have embraced debit cards for obvious reasons--they are
fast, safe, and accepted around the world. It is consumers who will be
severely affected by the Government-mandated price control in the
Federal Reserve's proposed rule. It will cause new consumer fees,
probably including checking account fees, and likely push low-income
customers out of the banking system.
Such an important change did not receive the thoughtful and
thorough consideration in Congress it deserved. The process, in fact,
was deeply flawed. It should be revisited and Congress should take
immediate action to stop the proposed Federal Reserve interchange rule
from being implemented.
The ABA is grateful for the willingness of Senators Tester and
Corker, and the many other cosponsors of S. 575 to reconsider the
harmful, unintended consequences that will result from the Federal
Reserve's proposal to implement the Durbin Amendment.
S. 575 rightly recognizes that the Federal Reserve's rule will
cause significant and immediate harm to community banks, consumers and
the broader economy. Various concerns over the proposed rule have been
raised in recent weeks by bank regulators, including Federal Reserve
Chairman Ben Bernanke and Sheila Bair, chairman of the Federal Deposit
Insurance Corporation, and by numerous lawmakers from both sides of the
political aisle.
The clear implication is that more time to study the impact of this
provision is definitely warranted, especially considering that the
Durbin Amendment was adopted at the 11th hour, without hearings,
Committee action or informed debate.
It is for these and other reasons that we strongly support S. 575
and are thankful that the Senate has taken the first step toward
stopping the Fed's rule and thereby protecting consumers, banks and the
broader economy. We urge quick action to enact this important piece of
legislation.
II. The Cumulative Burden of Hundreds of New or Revised Regulations
Will Lead to a Massive Consolidation of the Banking Industry
Banks have to be profitable and provide a reasonable return to
investors. If they do not, capital quickly flows to other industries
that have higher returns. The Dodd-Frank Act, in combination with
intense regulatory over-reaction, has increased expenses, decreased
potential revenue, and limited community bank access to capital. Added
to greater uncertainty about new regulatory and legal risks, these
pressures directly take resources away from the true business of
banking--making loans in local communities.
The impact of Dodd-Frank and bank supervision on community banks
can be broken down into four categories: (1) higher operating costs to
comply with scores of new rules; (2) pressures on capital; (3)
restraints that may drive community banks out of lines of business; and
(4) greater uncertainty and risk. As I will discuss in the next
section, all of these will have severe consequences for consumers and
communities that banks serve.
1. Dodd-Frank Rules Increase Costs of Doing Business
The Dodd-Frank Act will have an enormous and negative impact on all
community banks. Already there are nearly 2,000 pages of new proposed
rules and there will be many thousands more as the 200+ rules under the
Act are promulgated. This is on top of the 50 new or expanded
regulations affecting banks over the 2 years leading up to the
enactment of the Dodd-Frank Act. This flood of new regulations is so
large that regulators are urging banks to add new compliance officers
to handle it.
The Farmers Bank is typical of many community banks in the U.S.,
and I know how demanding the crush of paperwork is for my staff. It is
hard enough to deal with one new regulation or a change in an old one,
but with reams of new proposals and reams of final regulations, it is
overwhelming. We used to close many of our loans internally with our
loan officers assuring compliance with all the requirements. This model
simply will not work now with all the new requirements and we are very
likely to seek outside compliance help to assure that we are in
compliance.
Managing compliance with these new requirements adds time and
costs--all of which makes it more difficult and costly to make loans to
our customers. It is a sad commentary when our investment dollars this
year and next--and probably longer--will be spent on compliance with
the Dodd-Frank Act rather than making new loans, products and services
available. There are many community banks smaller than mine, and I
cannot imagine the pressure they face with fewer employees. The
cumulative burden of hundreds of new or revised regulations may be a
weight too great for many smaller banks to bear.
Of particular concern is the additional regulatory and compliance
burden expected once the Bureau of Consumer Financial Protection (CFPB)
becomes fully operational. This new bureaucracy--expected to hire over
1,200 new staff--will certainly impose new obligations on community
banks--banks that had nothing to do with the financial crisis and
already have a long history of serving consumers fairly in a
competitive environment.
One of the claims was that small banks would be exempt from the new
CFPB. But small banks are not exempt. All banks--large and small--will
be required to comply with rules and regulations set by the CFPB,
including rules that identify what the CFPB considers to be ``unfair,
deceptive, or abusive.'' Moreover, the CFPB can require community banks
to submit whatever information it decides it ``needs.'' There are also
many other new regulatory burdens flowing from the Dodd-Frank Act
empowerment of the CFPB which will add considerable compliance costs to
every bank's bottom line.
It is true that although the CFPB will not regularly examine
community banks for compliance with its rules, it can join the
prudential regulator by doubling up during any such exam at the CFPB's
sole discretion. It is also true that bank regulators will examine for
compliance at least as aggressively as the CFPB would do independently.
In fact, the FDIC has created a whole new division to implement the
rules promulgated by the new CFPB, as well as its own prescriptive
supervisory expectations for laws beyond FDIC's rule-making powers.
Thus, the new legislation will result in new compliance burdens for
community banks and a new regulator looking over their shoulders.
Dodd-Frank also adds to the compliance burden by unleashing a
fragmented enforcement mechanism that empowers Attorneys General to
invent their own interpretations of Federal standards and bring actions
without regard for the exam conclusions of the CFPB or the prudential
regulators. This generates increased regulatory uncertainty and
litigation risk that will chill innovation and raise barriers to market
competition, especially for banks without an army of lawyers to
navigate the enforcement minefield.
Where the CFPB should focus its energies is on supervision and
examination of nonbank financial providers. Many of the problems that
led to the financial crisis began outside the regulated banking
industry and creation of the CFPB was largely a result of this enormous
gap in the system that ultimately led to problems. We urge Congress to
ensure that this focus on nonbanks is a priority of the CFPB.
My bank's philosophy--shared by community banks everywhere--has
always been to treat our customers right and do whatever we can to make
sure that they understand the terms of the loans they are taking on and
their obligations to us. We will continue to do this, but now there
will be many new hurdles that we will have to jump to serve our
customers' most basic needs that will inevitably add cost, time, and
hassle for my customers.
The bottom line is the more time bank personnel devote to parsing
regulatory requirements, the less time they can devote to the financial
and credit needs of bank customers. Adding such a burden on banks that
had nothing to do with the financial crisis constitutes massive
overkill. In the end, this cumulative burden will only impede fair
competition among trusted providers seeking to serve responsible
customers.
Much needs to be done to reverse the burdens Dodd-Frank threatens
to impose through the CFPB. We recommend the following steps as only a
beginning:
Eliminate the expansive definition of ``abusive'' practices
since appropriate use of existing unfair and deceptive
practices authority is more than adequate;
Prohibit Attorneys General from enforcing Federal standards
subject to Federal supervision, or at least limit such actions
to remedy only conduct occurring after the last CFPB or
prudential regulator examination; and
Prevent States and prudential regulators from augmenting or
interfering with consumer protections otherwise covered by CFPB
rules.
2. Access to New Capital for Community Banks Is Problematic
Capital is the foundation upon which all lending is built. Having
sufficient capital is critical to support lending and to absorb losses
when loans are not repaid. In fact, $1 worth of capital supports up to
$10 in loans. Most banks entered this economic downturn with a great
deal of capital, but the downward spiral of the economy has created
losses and stressed capital levels. Not surprisingly, when the economy
is weak, new sources of capital are scarce.
The timing of the Dodd-Frank limitations on sources of capital
could not have been worse, as banks struggle to replace capital used to
absorb losses brought on by the recession. While the market for trust
preferred securities (which had been an important source of capital for
many community banks) is moribund at the moment, the industry needs the
flexibility to raise capital through various means in order to meet
increasing demands for capital. Moreover, the lack of readily available
capital comes at a time when restrictions on interchange and higher
operating expenses from Dodd-Frank have already made building capital
through retained earnings more difficult.
These limitations are bad enough on their own, but the consequences
are exacerbated by bank regulators piling on new requests for even
greater levels of capital. As I travel the country, I often hear how
regulators are pressing many banks to increase capital-to-assets ratios
by as much as 4 to 6 percentage points--50 to 75 percent--above minimum
standards. For many banks, it seems like whatever level of capital they
have, it is not enough to satisfy the regulators. This is excess
capital not able to be redeployed into the market for economic growth.
Thus, to maintain or increase capital-to-assets levels demanded by
the regulators, these banks have been forced to limit, or even reduce,
their lending. The result: the banking industry becomes smaller while
loans become more expensive and harder to get.
Ever-increasing demands for more capital puts a drag on the economy
at the worst possible time for our Nation's recovery. Moreover, it
works at cross purposes with banks' need for the strong and sustainable
earnings that will be the key to addressing asset quality challenges.
Therefore, anything that relieves the increasing regulatory demands for
more capital will help banks make the loans that are needed for our
Nation's recovery.
3. Dodd-Frank Rules May Drive Community Banks Out of Lines of Business
Congress must be vigilant in its oversight of the efforts to
implement the Dodd-Frank Act to ensure that rules are adopted only if
they result in a benefit that clearly outweighs the burden. Already we
are seeing proposals--such as those implementing the rules regarding
interchange, municipal advisors, and swaps transactions--that fail that
simple test. Some rules under Dodd-Frank, if done improperly, will
literally drive banks out of lines of business. New rules on
registration as municipal advisors and on mortgage lending are two
particularly problematic provisions.
New SEC rules on municipal advisors--if done improperly--
will drive community banks out of providing basic
banking products to local and State governments
ABA believes that Dodd-Frank intended to establish a regulatory
scheme for unregulated persons providing advice to municipalities with
respect to municipal derivatives, guaranteed investment contracts,
investment strategies or the issuance of municipal securities. Most
community banks, like The Farmers Bank, do not deal in bonds or
securities. But community banks do offer public sector customers
banking services and we are regulated closely by several Government
agencies.
The Securities and Exchange Commission has proposed a very broad
definition of ``investment strategies'' that would cover traditional
bank products and services such as deposit accounts, cash management
products and loans to municipalities. This means that community banks
would have to register as municipal advisors and be subject to a whole
new layer of regulation on bank products for no meaningful public
purpose. The result of this duplicative and costly regulation:
community banks like mine may decide not to provide banking services to
their local muncipalities, forcing these local and State entities to
look outside of their community for the services they need. This
proposal flies in the face of the President's initiative to streamline
Federal oversight and avoid new regulations that impede innovation,
diminish U.S. competitiveness, and restrain job creation and economic
expansion.
We urge Congress to oversee this implementation and ensure that the
rule addresses unregulated parties and that neither Section 975 of
Dodd-Frank nor its implementing regulation reaches through to
traditional bank products and services.
New proposed mortgage rules likely to drive many community
banks out of mortgage lending
The housing and mortgage markets have been battered in recent years
and are still struggling to recover. Addressing the systemic problems
which led to the crisis is critical, but care must be taken to avoid
unnecessary actions that do not address systemic issues and which could
further destabilize the fragile recovery. We have grave concerns that
the risk retention proposal issued by the regulators last week will
drive community banks from mortgage lending and shut many borrowers out
of the credit market entirely. It is true that the proposal's immediate
impact is muted by the fact that loans sold to Fannie Mae and Freddie
Mac while they are in conservatorship escape risk retention. However,
once the rule's requirements are imposed broadly on the market (should
they be adopted) they would likely shut out many borrowers entirely and
act to destabilize an already fragile market. Since it is also the
stated goal of both the Congress and the Administration to end the
conservatorship of Fannie and Freddie, it is important that risk
retention requirements be rational and non disruptive when they are
applied broadly to the market. The rule as proposed does not meet those
tests.
Therefore, ABA urges Congress to ensure that the regulators revise
the risk retention regulation before it is imposed on the mortgage
market broadly. Specifically we recommend:
Exemption from risk retention provisions must reflect
changes in the market already imposed through other legislative
and regulatory change.
In the Dodd-Frank Act, Congress determined that some form
of risk retention was desirable to ensure that participants in
a mortgage securitization transaction had so-called ``skin in
the game.'' The goal was to create incentives for originators
to assure proper underwriting (e.g., ability to repay) and
incentives to control default risk for participants beyond the
origination stage. There have already been dramatic changes to
the regulations governing mortgages. \1\ The result is that
mortgage loans with lower risk characteristics--which include
most mortgage loans being made by community banks today--should
be exempted from the risk retention requirements--regardless of
whether sold to Fannie Mae and Freddie Mac or to private
securitizers. Exempting such ``qualified residential mortgage''
loans (QRM) is important to ensure the stability and recovery
of the mortgage market and also to avoid capital requirements
not necessary to address systemic issues. However, the QRM as
proposed is very narrow and many high-quality loans posing
little risk will end up being excluded. This will inevitably
mean that fewer borrowers will qualify for loans to purchase or
refinance a home.
---------------------------------------------------------------------------
\1\ For example, changes have been made under the Real Estate
Settlement Procedures Act (RESPA), the Truth in Lending Act (TILA), and
the Secure and Fair Enforcement for Mortgage Licensing (SAFE) Act. In
addition, the Federal bank agencies have just announced significant
changes to appraisal standards.
For example, for the loan to qualify, borrowers must make
at least a 20 percent down payment--and at least 25 percent if
the mortgage is to be a refinance (and 30 percent if it is a
---------------------------------------------------------------------------
cash-out refinance).
Certainly loans with lower loan-to-value (LTV) ratios are
likely to have lower default rates, and we agree that this is
one of a number of characteristics to be considered. However,
the LTV should not be the only characteristic for eligibility
as a ``Qualified Residential Mortgage,'' and it should not be
considered in isolation. Setting the QRM cutoff at a specific
LTV without regard to other loan characteristics or features,
including credit enhancements such as private mortgage
insurance, will lead to an unnecessary restriction of credit.
To illustrate the severity of the proposal, even with private
mortgage insurance, loans with less than 20 percent down will
not qualify for the QRM.
ABA strongly believes that creating a narrow definition of
QRM is an inappropriate method for achieving the desired
underwriting reforms intended by Dodd-Frank.
The Risk Retention Requirements as proposed will inhibit
the return of private capital to the marketplace and will make
ending the conservatorship of Fannie Mae and Freddie Mac more
difficult.
The proposal presented by the regulators will make it
vastly more difficult to end the conservatorship of Fannie and
Freddie and to shrink FHA back to a more rational portion of
the mortgage market. As we observed earlier, under the proposed
rule, loans with a Federal guarantee are exempt from risk
retention--including loans sold to Fannie Mae and Freddie Mac
while they are in conservatorship. Because of their
conservatorship status, the GSEs have the backing of the
Federal Government. FHA loans (as well as other federally
insured and guaranteed loan programs) are also exempt. Since
almost 100 percent of new loans today being sold are bought by
Fannie and Freddie or insured by FHA--and as long as these GSEs
can buy loans without risk retention--it will be dramatically
more difficult for private securitizers to compete. In fact,
the economic incentives of the proposed risk retention strongly
favor sales of mortgages to the GSEs in conservatorship and not
to private securitizers. Thus, this proposal does not foster
the growth of private label securitizations that would reduce
the role of Government in backing loans.
Equally important is the fact that the conservatorship
situation is unsustainable over the long term. That means that
eventually, these highly narrow and restrictive rules would
apply to a much, much larger segment of the mortgage market.
That means that fewer borrowers will qualify for these QRM
mortgage loans and the risk retention rules make it less likely
that community banks will underwrite non-QRM--but prudent and
safe--loans. Some community banks may stop providing mortgages
altogether as the requirements and compliance costs make such a
service unreasonable without considerable volume. Driving
community banks from the mortgage marketplace would be
counterproductive as they have proven to be responsible
underwriters that have served their borrowers and communities
well.
The imposition of risk retention requirements to improve
underwriting of mortgage loans is a significant change to the operation
of the mortgage markets and must not be undertaken lightly. ABA urges
Congress to exercise its oversight authority to assure that rules
adopted are consistent with the intent of the statute and will not have
adverse consequences for the housing market and mortgage credit
availability.
There are other related concerns affecting housing that need to be
addressed by Congress as well. In particular, Congress needs to make
the ``Qualified Mortgage'' in Title XIV a true safe harbor and ensure
that it does not unnecessarily constrict credit. Title XIV of Dodd-
Frank sets out new consumer protections for mortgage loans. As defined
in Title XIV, a Qualified Mortgage (QM) is one which has specific
features and is underwritten in such a way that it is presumed to meet
these consumer protection standards. That presumption, however, can be
rebutted--subjecting the lender to significant potential liability. The
Qualified Mortgage definition (as set in statute and as refined through
regulation) also serves as a limitation on the Qualified Residential
Mortgage (QRM) standard discussed above because the QRM cannot be
broader than the QM. As the law stands now, the Federal Reserve Board
(and eventually the CFPB after the transfer of powers) can unilaterally
narrow both the QM and QRM.
To avoid inadvertent and unintended impacts on safety and soundness
as well as credit availability, ABA strongly urges Congress to require
that any changes which could narrow the eligibility requirements for
the QM be undertaken jointly with the regulators responsible for
determining eligibility under the QRM.
4. Regulatory Risk and Uncertainty Are Rising, Reducing Incentive To
Lend
Businesses--including banks--cannot operate in an environment of
uncertainty. Unfortunately, Dodd-Frank increases uncertainty for banks,
and as a consequence, raises credit risks, raises litigation risks and
costs (for even minor compliance issues), leads to less hiring or even
a reduction in staff, makes hedging risks more difficult and costly,
and restricts new business outreach. All of this translates into less
willingness to make loans. In fact, banks' biggest risk has become
regulatory risk. Let me illustrate the regulatory risk and uncertainty
with four examples: (1) the unknown burden that will arise from the
Bureau of Consumer Financial Protection; (2) the potential lawsuits
that may arise on preemption; (3) the potential risk of future price
controls following the precedent set by the Durbin Amendment; and (4)
the potential loss of effective methods to hedge risk from rules on use
of swap contracts.
The Nature and Extent of Rules From CFPB Are Unknown
As discussed above, the CFPB has significant authority to create
new rules for consumer lending. What will happen is unknown, but it
does create potential litigation risk for actions taken now that may
conflict with the ultimate rules devised. The expectation of
significant new disclosures will translate into less willingness to
lend (and therefore less credit extended overall), greater costs for
any loans that are made, and higher costs to borrowers that still have
access to credit to cover the added risks undertaken by banks.
Preemption Uncertainty and State Attorneys General Given
More Power
One important example of uncertainty and unease created by Dodd-
Frank arises from the provisions regarding preemption. Congress
explicitly preserved in the Dodd-Frank Act the test for preemption
articulated by the United States Supreme Court for deciding when a
State law is preempted by the Federal laws that govern national banks'
activities. Nevertheless, any mention of the preemption standard in a
statute is likely to generate lawsuits from those who argue that the
standard somehow has changed.
The standard for Federal thrifts has changed, from an ``occupation
of the field'' test to the same ``conflicts'' test that has applied,
and continues to apply, to national banks. This creates uncertainty,
will lead to years of litigation, and places savings associations at
greater risk of suits over whether a patchwork of State laws applies.
The Dodd-Frank Act preemption provisions will affect all banks,
including State-chartered banks and thrifts that benefit from wild-card
statutes. State attorneys general will have greater authority to
enforce rules and regulations, specifically including those promulgated
by the CFPB. Moreover, in the case of State-chartered institutions, the
State AGs may enforce the Dodd-Frank Act even in the absence of
implementing regulations. This means that State AGs soon may be in the
business of deciding what is an unfair, deceptive, or abusive act or
practice for State banks.
Price Control Precedent Poses Future Risks
As discussed above, Government involvement in price controls
related to interchange fees will create many negative unintended
consequences. But the concern about the Durbin Amendment goes far
beyond the impact on my bank, my customers, and the economy. It sets a
dangerous precedent, suggesting that financial institutions may be
subject to future, unknowable price controls on other financial
products and services, undermining important free-market principles.
We have always accepted the operational, reputational, and
financial risk associated with developing new products and services and
making them available to millions of consumers. Now financial
institutions risk losing their investments of billions of dollars into
improvements of existing products and services, and the creation of new
ones, through Government price controls. Why would any business invest
in an innovative product knowing the Government ex post facto will
interfere and completely dismantle its free-market business model by
imposing price controls? The Durbin Amendment serves as a strong
disincentive for innovation and investment by financial institutions in
other emerging payment systems and financial products and services. In
the end, it is the American public who suffers.
Banks Face Uncertainty and Higher Risk as Regulators
Implement Swaps Rules
It is difficult, if not impossible right now, for banks to
determine how the new swaps regulatory framework mandated by Dodd-Frank
will affect the way banks do business. We do not know yet how the swaps
exchanges will operate, what impact the clearing requirements will have
on banks' ability to customize swaps, or even which banks and
transactions will be subject to each of the new rules. For example,
while other end users will be exempt from complex and costly clearing
requirements, we are waiting to find out if our community banks will
receive the same treatment. If not, then these banks might not be able
to use swaps and the end result would be reduced lending, increased
risk for banks, and higher costs for customers if banks cannot hedge
the risk.
Beyond the uncertainty of the current situation, it is critical to
ensure that banks have sufficient time to consider the implications
that the proposed swaps regulations will have on their ability to
manage business risks. Considering the number of new rules that are
needed and the way they are interconnected, doing them hastily could
cause serious economic harm.
We urge Congress to actively oversee the Commodity Futures Trading
Commission (CFTC) and SEC as they implement the new swaps requirements
to be sure there are no adverse affects on lending or competition for
U.S. banks. We also encourage Congress to enact legislation explicitly
granting small banks the same exemption from swaps clearing
requirements that is available to other end users.
III. Consequences for Banks, Consumers, and the Economy Are Severe
Certainly, I want my bank to be successful, as do all of my fellow
bankers throughout the country. Every day, we are facing new challenges
that threaten our very existence. But for community banks, it goes
beyond just our parochial interests to be successful. We are very much
a part of our community. It is why every bank in this country
volunteers time and resources to make their communities better. If the
relentless pressures on our small banks are not relieved, the loss will
be felt far beyond the impact on any bank and its employees. It will
mean something significant has been lost in the community once served
by that bank.
Ultimately, it is consumers that bear the consequences of
Government imposed restrictions. The loss of interchange income will
certainly mean higher costs of using debit cards for consumers. Greater
mortgage restrictions and the lack of certainty on safe harbors for
qualified mortgages means that community banks may no longer make
mortgage loans or certainly not as many. Higher compliance costs mean
more time and effort devoted to Government regulations and less time
for our communities. Increased expenses often translate into layoffs
within the bank.
Thus, jobs and local economic growth will slow as these impediments
inevitably reduce the credit that can be provided and the cost of
credit that is supplied. Fewer loans means fewer jobs. Access to credit
will be limited, leaving many promising ideas from entrepreneurs
without funding. Capital moves to other industries, further limiting
the ability of banks to grow. Since banks and communities grow
together, the restrictions that limit one necessarily limit the other.
Lack of earning potential, regulatory fatigue, lack of access to
capital, limited resources to compete, inability to enhance shareholder
value and return on investment, all push community banks to sell. The
Dodd-Frank Act drives all of these in the wrong direction and is
leading to consolidations. The consequences for local communities are
real. As the FDIC noted: ``The conversion of a once-main-office to a
branch is sometimes accompanied by reductions in customer services,
customer service hours, and managerial authority and decision-making
discretion.''
The Farmers Bank will survive these changes. I fear that many other
community banks may not. I have spoken to many bankers throughout the
country who describe themselves as simply miserable. Some have already
sold their banks; others plan to do so once the economic environment
improves. The Dodd-Frank Act was intended to stop the problem of too-
big-to-fail, yet now we have even bigger institutions; ironically, the
result may be that some banks will be too-small-to-survive the
onslaught of the Dodd-Frank rules.
Conclusion
An individual regulation may not seem oppressive, but the
cumulative impact of all the new rules plus the revisions of existing
regulations is oppressive. The regulatory burden from Dodd-Frank and
the excessive regulatory second-guessing must be addressed in order to
give all banks a fighting chance to maintain long-term viability and
meet the needs of local communities everywhere.
It is important to understand that our bank, indeed, any small
business, can only bear so much. Most small banks do not have the
resources to easily manage the flood of new rules. Higher costs,
restrictions on sources of income, limits on new sources of capital,
regulatory pressure to limit or reduce lending in certain sectors, all
make it harder to meet the needs of our communities. Ultimately, it is
the customers and community that suffer along with the fabric of our
free market system.
______
PREPARED STATEMENT OF PAUL REED
President, The Farmers Bank and Savings Company, Pomeroy, Ohio, on
behalf of the Ohio Bankers League
April 6, 2011
Mr. Chairman, Members of the Financial Institutions Subcommittee,
my name is Paul Reed. I am president and chief executive officer of The
Farmers Bank and Savings Company in Pomeroy, Ohio. Farmers is a
community bank serving a largely Appalachian market. I was born and
raised in my community. That same can be said of most of the other
bankers in my market. We serve those we grew up with.
I appreciate your invitation to testify on behalf of the Ohio
Bankers League. My association represents most of Ohio's commercial
banks, savings banks, and savings and loan associations.
I hope to address three themes in my testimony:
A good community bank plays a unique role in economic
development important to public policy.
The regulatory structure in 2008 unintentionally but
effectively empowered abuse.
Dodd-Frank does too little to simplify and rationalize an
extraordinarily complex and ineffective financial regulatory
structure.
I'll start my testimony with a question--why should community
banking matter to Congress?
My answer is pretty simple. While larger financial institutions
care about their customers, they do not care where they live. That
doesn't make big guys bad. It does mean community banks are a critical
element of economic redevelopment in many communities.
As a community bank I have a vested interest in the economic and
social health of my local market. If my customer cannot find a good job
in my community and leaves, I cannot follow him. So my bank's
operations must closely sync with what my community needs.
The news media has become very sloppy with the term bank, so let me
call myself a traditional bank. There is a difference, important to
national policy, between a traditional bank and the various forms of
investment companies. I need my customer to be successful. I want long
term customers. I win if my customer is successful. Contrast that with
the investment bank for which the deal is too often an end in itself
rather than the means to the end.
Because I have a practical loan size limit, my bank has always
focused on small business. That is our expertise. I am close to my
customers which, if I do my job well, will give me added insight. I
should be able to make more loans safely than my bigger, distant
competitors. Many successful small businesses in Ohio, including those
that have grown to be large, started with a close call on a loan, made
by a community bank which could say yes safely because it knew its
customer.
Recently, walking down a hallway in my bank, I overheard a customer
talking to another bank officer. The customer said ``I didn't know what
to do; but knew if I came to see you, you would.'' Any good community
bank hears that sentiment every day.
As we forge recovery from a very painful recession, small
businesses in the communities I serve need me to customize financial
tools to answer their needs. I know you want me to do that; but the
thousands and thousands of pages of regulation we labor through crush
our ability to respond effectively, efficiently, and quickly. Looking
to the future, Dodd-Frank will add more thousands of pages of new
regulations.
This last statement should not be interpreted as opposition to
effective regulatory modernization. The country needs effective,
efficient financial regulation. We all will suffer if we fail to
achieve it. Long before the financial crisis, most bankers I know had
been calling for a streamlined, modern system which justified public
confidence. Without question our regulatory safety net had developed
severe flaws. Dodd-Frank improves parts but it does not do enough. As a
community banker, I appreciate the steps taken to try to benefit me.
Unfortunately, I fear there are unintended consequences Congress did
not consider. Let me provide a few examples.
Deposit Insurance. In Dodd-Frank, Congress changed the basis for
deposit insurance premiums from deposits to assets. That change has
been touted by some as a great victory for community banks that fund
most of their loans from local deposits. Ignored in that analysis are
FDIC's subsequent actions to increase its target reserve ratio from
1.25 to 2.0, an increase of 60 per cent. Moreover, the FDIC eliminated
the threshold beyond which it would charge no premium because the fund
was judged adequately capitalized. Today, I am paying premiums at a
historically high rate because an obsolete regulatory structure failed
to catch bad guys in time. These changes mean that I will continue to
pay more than I have historically paid, not less, for a very long time.
It does make sense to build the insurance fund reserves in good
times; but please consider that every dollar I pay in deposit insurance
translates into ten dollars I cannot lend. We need to stop the
traditional swing of the regulatory pendulum from too lax in good
times, to too punitive in the wake of economic troubles. It is the good
actors who will pay this greatly inflated bill. The increase is huge
despite the many other changes which will limit future risk to the
fund. And under it all, the overly complex, inflexible regulatory
structure that let the bad guys run rampant is too little changed.
Capital. Capital is a challenge for community banks. Historically,
most community bank capital came from the leaders of our communities
who wanted a locally focused bank. That source was doubly helpful
because investors cared about long term benefit to the community as
well as the return on their investment. A troubled economy both
increases the need for capital while it reduces the ability of those
traditional sources to invest. A further barrier to investment comes
from an expensive regulatory regime for traditional banks which
artificially constrains the potential return on any investment.
A tool the marketplace had evolved to address this dilemma was the
trust preferred security. Some of the early banks closed by regulators
proved to have invested in poorly underwritten trust preferred
securities. As a result FDIC lost money. In reaction the Senate adopted
the Collins amendment to Dodd-Frank that will likely kill this source
of funding for community banks. Dodd-Frank created nothing to replace
it. The right response would have been to limit banks' ability to
directly invest in these securities. It was counterproductive to
cripple the use of trust preferred securities as a tool for healthy
community banks looking to raise funds from investors outside the
banking industry.
Too-Big-to-Fail. Community banks and the Nation were grievously
harmed by financial institutions grown too-big-to-fail. The risks from
a Fannie or AIG were not new, yet nothing substantive was done to
control them. We heard there was no Government guarantee of the very
big against failure. Of course there was.
For years I faced funding costs higher than the largest financial
institutions because the marketplace knew they were guaranteed against
failure. Proportionally I also paid far higher regulatory costs than my
large competitors.
The marketplace does not believe Dodd-Frank has ended too-big-to-
fail. The Wall Street Journal recently reported that the funding costs
for the biggest institutions are still 78 basis points lower than mine.
While we all supported ending too-big-to-fail, the market suggests we
have not done so. And we continue to aggressively, if unintentionally,
to forge what is in affect ``too small to survive.''
Debit card transaction fees. I know the intent of Dodd-Frank was to
exempt community banks from the rule that set a ceiling on debit
interchange fees at roughly a fourth of my cost. However, my
understanding is the choice of the transaction processor is the
retailer's. Processors competing for business from the big box stores
will drive down the price I am paid. In the real world, the exemption
will prove fiction.
The campaign by retailers focused on the big and only told part of
the story. When my customers use debit cards I provide them, it saves a
merchant on each transaction over their acceptance of checks or cash.
Additionally, it is the bank that faces the risk of fraud. Only the
merchant will have the contact when it can check to see that the card
is not stolen. Few check. In 2009, a case of fraud involving a single
merchant cost me more than our entire interchange income for the year.
Banking is very competitive. Competition has driven banks to spend
interchange income on benefits we hope will attract customers--free
checking accounts, convenient branches, more ATMs. Now my debit account
income will be far less than my expense. Home Depot tells financial
analysts my loss will translate into $35 million in an annual, windfall
profit to its shareholders. Where is the consumer benefit?
A focus on trees ignoring the forest. In the lead-up to the global
financial meltdown, a significant portion of the financial services
market evaded governmental oversight. People motivated by greed flowed
into the enforcement vacuum. Some were criminals. Many newer market
entrants evaded governmentally imposed costs of doing business.
Banks must meet significant capital requirements. We must pay the
full cost of regular, onsite, extensive examination. We pay for deposit
insurance. We pay material sums for personnel and paperwork required by
voluminous, too often poorly crafted regulation. Government says banks
are the most important financial service provider. It sets up an
extensive system to prevent failure and protect consumers if it does
happen. Then policy and practice perversely tilt the competitive
playing field steeply against traditional banks. And community banks
suffer the greatest harm because scale provides compliance efficiency.
Consumer Financial Protection Bureau. To right consumer wrongs
Congress created the CFPB. It promises clearer, simpler disclosures and
universal coverage. The goal is right, but Congress chose to exempt a
substantial percentage of financial service providers. Many exempted
companies offer direct or functional substitutes for what I sell.
Inevitably that very artificial wall will spawn more providers
operating outside it.
I do have a community bank exemption from direct examination by
CFPB. Congress determined that my primary regulator will continue to
enforce compliance rules, now written by the new bureau. CFPB will
handle the big guys. That exemption sounds like it should be helpful to
me; but please understand any time a rule changes, whether for good or
bad, traditional banks face a significant burden in replacing forms,
systems, and then retraining. The smaller the bank, the harder it will
prove to absorb these costs without losing competitiveness.
Today and tomorrow my regulator will regularly come into my bank
with a large examination team to probe every aspect of my operations.
That is effective but it is also a huge disruption to business. In
contrast, no Government compliance examiners visited my nonbank
competitor's office. There is little reason to believe they will
tomorrow either. And to the extent the new bureau does examine my non
bank competitor; the cost of that exam will be paid for by the Federal
Reserve System. I get a bill.
I want to emphasize this point. The consumer's safety net failed to
keep pace with the marketplace. It failed to recognize and oversee new
providers of functionally equivalent products and services. As a result
costs were imposed on banks but not on new non bank competitors. That
meant banks continually struggled to be price competitive. Government
regulation often had the perverse impact of motivating consumers to use
a company where they would have little or no protection. One reason
many of these problematic new financial companies escaped attention was
that they were individually small; but they became very large in number
and even larger in damaging impact. CFPB is not being developed to
catch or prevent abuse in small companies where history suggests it
will likely occur.
There had long been warning voices within Congress; but for a
variety of reasons Congress as a whole rarely acted. One relevant
example--if you read transcripts from Senate Banking Committee hearings
four decades ago, you will find then Chairman William Proxmire
repeatedly pointing to risks to the public in Freddie and Fannie that
arguably led both to fail.
Did we fail to act because an existing agency was perceived as too
politically powerful, or even if inefficient, that its purpose was too
worthy? Did inconsistent Congressional oversight mean we failed to
detect a foundation built on sand? Did divided Committee jurisdiction
cost Congress important perspective?
Over the years we have responded to crises by adding agency after
agency. I cannot detect grand design. I would argue we mistook actions
for progress.
Predictably the multiplicity of inward looking financial regulators
resulted in glaring holes in our safety net. One good example--AIG told
State insurance departments that debt swaps weren't insurance. The SEC
apparently thought they were insurance. Ultimately no one looked to see
if AIG had the money to make good on its commitments.
Theoretically, to prevent conflict of interest U.S. policy
separates finance from commerce. We haven't always adhered to that
separation in practice. An example--we allowed Detroit automobile
companies to form captive finance companies that subsidized rates from
the price of the cars. It was hard for a bank that wasn't selling the
car, to compete with a 0 percent loan. Even though it was a shell game,
no Government agency intervened. Unfair competition largely drove banks
out of the auto finance business. The new auto lenders got bigger,
began mortgage lending, and soon grew so big they became ``too big to
fail.'' To add to the injury, we then pretended they had been banks all
along. We bailed the failed companies out in part by using the deposit
insurance fund which traditional banks had capitalized.
We failed to address other conflicts of interest. Unless a mortgage
broker closed a loan it didn't get paid. In some cases the broker
received a bonus if it convinced the consumer to buy unneeded extra
features. As a result the broker's needs fundamentally differed from
the borrower's. Yet no one in Government checked for misrepresentation
or fraud.
A car salesmen closing an auto loan faces the same conflict. Dodd-
Frank attempted to address the problem of the mortgage broker. However,
it specifically exempts the car salesman. We lack a comprehensive
theoretical regulatory concept. As a result we get very different
answers to very similar questions over time.
I have heard some observers conclude that the financial melt down
was the result of deregulation. Specifically, some have cited the
Gramm, Leach, Bliley Act. Whether you liked GLBA or not, there was
little deregulation in that bill. It simply acknowledged what had
already happened in the marketplace. What was completely absent from
the bill was any modernization of financial regulation to cope with
that new marketplace reality.
The OBL shared our concern about the shortcomings of Gramm Leach
Bliley with the then chairman of the House Financial Services
Committee. He acknowledged the shortcoming; but observed regulatory
turf had grown so entrenched in Washington, that it would take a crisis
to trigger modernization. Well, we have now suffered that crisis. And
we have gotten a 2,300 page bill. Some of its provisions do represent
progress. But I believe it missed fundamental flaws that continue to
plague our regulatory system.
The news last week brought an example of obsolete design when six
Federal agencies jointly issued a rule on mortgage risk retention in
response to the Dodd-Frank mandate. My point is not the rule--but six
agencies? That is the post Dodd-Frank world. Can so many be nimble,
efficient, effective, or timely? Can they detect the new marketplace
abuse? Or will the traditional agencies assume, as was the case
consistently on our path to financial meltdown, that the abuse was
somebody else's responsibility. In practice complexity seldom supports
effective or efficient.
As this country began to be victimized by predatory lending
mortgage securitization had allowed the invention of the mortgage
broker--tens of thousands of them. My understanding is the FTC had
jurisdiction over non bank consumer lending. Yet the FTC's structure
was not well suited to overseeing mortgage closings in this new, very
decentralized environment. Congress hadn't given FTC examiners so it
didn't systematically examine.
This new form of consumer loan broker wasn't paid unless the loan
closed. It wasn't penalized if the borrower couldn't repay. That
structure created powerful incentive to the broker to falsify and lie.
No Government agency looked to find the ones who were doing so.
In Ohio alone we estimate there were 12,000 mortgage brokers at the
high point. Theoretically their lending was covered by the many Federal
consumer protection laws dealing with mortgages. Mortgage documents
arriving on Wall Street appeared correctly filled out; but no one
checked for fraud or that consumers had been told the truth. Consumers
labored to protect themselves. Federally required mortgage closing
forms were so lengthy and complex that few read, let alone understood,
them. Where the lender was honest, there was no harm. When it was not,
we got predatory lending. Ohio became a national scandal of predatory
lending. When my State belatedly got around to licensing those brokers,
it discovered a very high percentage had criminal records.
Dodd-Frank does address those mortgage brokers. I hope that will
result in better consumer protection. But I fear we have missed the
lesson. Will we quickly detect and effectively respond to the next
marketplace invention which seeks to avoid governmental imposed costs
of consumer protection? History suggests that is unlikely.
Why did dishonest mortgage brokers escape detection for so long?
They were small.
Individually they were inconsequential. Collectively they collapsed
the global financial world. No Federal regulator saw them as their
responsibility. States pled poverty even when they saw the problem.
Historically, our laws have tended to address specific types of
companies. Dodd-Frank attempted to refocus on the product; but my
understanding is that is the model the new Financial Consumer
Protection Bureau is using to organize itself focused on provider not
product or service. If that is correct I think that is the wrong model.
Would it not make more sense to make rules consumer centric?
Should not all functionally equivalent products be regulated
equally?
Should not Government imposed costs of business fall on all
competitors evenly?
Should the consumer have some assurance of honest treatment
regardless of provider?
If compliance costs do not favor one competitor over another, then
competition works to the consumer's advantage. We need to end
regulatory gaps driven either by regulatory or Congressional committee
jurisdiction at the expense of the consumer.
No one ever would have designed the regulatory structure we have
today on purpose. It is the product of historic accident, not grand
design. That it has worked as well as it has is amazing. It speaks to
the many good people that work for the agencies. That it has not worked
as well as the American public deserves, is testimony to the fact many
successive Congresses have failed to systematically address evolution
of the marketplace. We have an alphabet soup of moving pieces in this
protective engine. Many of the pieces were machined to fit engines in a
different century. And today's engine, using those parts, gets very bad
mileage and breaks down frequently.
Before Dodd-Frank we had too many regulators, and too many holes
between them. Dodd-Frank gave us more regulators. We still have the
gaping holes. I am asked to believe that's progress.
Let me close with a few suggestions.
Community Bank Regulator. The Dodd-Frank Act did eliminate an
agency. In July the Office of Thrift Supervision disappears, giving the
OCC jurisdiction over federally chartered savings and loan institutions
and the FDIC that authority over State charters.
Nevertheless, community banks will wind up with more regulators. We
have already discussed CFPB. There are other examples.
Today OTS examines both savings and loan companies and their
holding companies. That makes sense to me. Corporate veils shouldn't
frustrate public protection. Transactions in either the parent or the
bank can affect the safety of the other. Dodd-Frank transfers thrift
holding company jurisdiction to the Federal Reserve. It transfers
regulation of the bank to one of two other agencies. Two different
regulators with overlapping turf create opportunity for inefficiency
and ineffectiveness.
I would submit that Congress might have served the consumer and
country better by creating a community bank regulator, merging the
current oversight of smaller, healthy banks and their holding companies
conducted by either OCC, FDIC, OTS, or Federal Reserve. Freed of small
bank exam responsibility, the agencies could concentrate on areas of
greatest national risk. The new community bank regulator could focus on
rules and examinations that work for small banks and their customers.
Community Bank Examinations. I want to briefly address the bank
examination process itself. Its current form can drive focus on form
over substance. I understand it is easier to check to see if there is a
policy in a file, than it is to determine whether practice works. It is
easier to check to see that collateral protects against any loss,
rather than to evaluate lender judgment in trying to help a small
business navigate through the land mines of a serious recession. I do
understand the risk Washington would take when it tells examiners that
if a bank's management team in both ethical and competent that their
job is to help the bank navigate the mine field with advice and
counsel. Some judgments will be wrong. Nevertheless, the question
should always be what approach leads to the greatest success not that
which best shields the regulator from blame.
I have great respect for the individuals that make up the teams
that examine my bank. They are bright and well intentioned. But too
little in exams really deals with what is most important to my
community. During my last exam, a few weeks ago, there was little
discussion over the regulator's decision to downgrade a loan to a small
business which had been a long time customer of the bank. The business
was troubled but we were paying close attention and working closely
with the business to try to help it survive. We had already taken steps
to fully protect the bank, and the customer was making payments. The
regulator's decision cut the funds I had available to lend and hampered
my flexibility in working with my customer. In contrast there was
extensive discussion on issues like depreciation schedules of minor
amounts which had little to do with my bank's safety and nothing to do
with the well-being of its customers.
We have evolved a system that is safest for regulators. The goal
must be one that is safer for the communities I serve. I believe one
reason for the system we have is that Congress flails regulators when
they are wrong. It rarely commends them for taking risks that result in
benefit for the economy.
More Rigorous Oversight. I can claim no expertise in politics, but
I suspect a Senator would not be rewarded were he to go back home and
campaign on the slogan ``I didn't introduce a single new bill; but I
worked hard to make sure that existing law and the rules worked well.''
However it is exactly that rigorous, unrelenting, painstaking,
unglamorous oversight we will need if we are to reinvigorate the
American economy and avoid a recurrence of the financial meltdown that
began in 2008.
I do recognize that we, as constituents, literally expect you to be
expert on everything in the universe. Demands on your time are
unrelenting. You individually cannot spend as much time looking and
listening as I want. However, you can systematically get your aides out
of the artificial environment defined by the beltway. Get them back
home talking with consumers, small businesses, farmer and community
bankers, so they understand the financial world your constituents live
in. And please dramatically expand systematic, rigorous oversight. Be
vigilant. Study carefully. Act only when the case to do so is
compelling. When you act, do so with comprehensive vision that
considers unintended consequence.
If you want to protect the consumer you must simplify the
structures that serve that end. Consumers must know how they are
protected and who protects them. Forge a modern regulatory system that:
looks through their eyes;
treats all functional competitors equally;
is designed to stop the bad guy from causing harm; but in
ways that do not keep good guys from innovation in response to
legitimate customer needs.
Thank you for the important step you take today.
Additional Material Supplied for the Record
LETTER SUBMITTED BY CHAIRMAN SHERROD BROWN
LETTER SUBMITTED BY SANDRA L. THOMPSON, DIRECTOR OF RISK MANAGEMENT
SUPERVISION, FEDERAL DEPOSIT INSURANCE CORPORATION
LETTER SUBMITTED BY JENNIFER KELLY, SENIOR DEPUTY COMPTROLLER FOR
MIDSIZE AND COMMUNITY BANK SUPERVISION, OFFICE OF THE COMPTROLLER OF
THE CURRENCY
PREPARED STATEMENT SUBMITTED BY THE RETAIL INDUSTRY LEADERS ASSOCIATION
Chairman Brown, Ranking Member Corker, and Members of the
Subcommittee:
On behalf of the Retail Industry Leaders Association (RILA), we
respectfully submit the following statement for the record with respect
to the Subcommittee's hearing titled ``The State of Community Banking:
Opportunities and Challenges.'' Our comments are specifically focused
on the importance of Section 1075 of the Dodd-Frank Wall Street Reform
and Consumer Protection Act (Dodd-Frank Act), which provides critically
needed reforms to the system for setting interchange fees with respect
to debit card transactions in this country.
By way of background, RILA is the trade association of the world's
leading and most innovative retail companies. RILA promotes consumer
choice and economic freedom through public policy and industry
operational excellence. Its members include more than 200 retailers,
product manufacturers, and service suppliers, which together account
for more than $1.5 trillion in annual sales, millions of American jobs
and operate more than 100,000 stores, manufacturing facilities and
distribution centers domestically and abroad.
Section 920 of the Electronic Fund Transfer Act (EFTA), added by
Section 1075 of the Dodd-Frank Act, requires that the Board prescribe
regulations to ensure that debit card swipe fees are ``reasonable and
proportional to the cost incurred by the issuer with respect to the
transaction'' for the purpose of ``authorization, clearance, or
settlement of a particular electronic debit transaction . . . .'' On
December 28, 2010, the Federal Reserve Board (Board) published a Notice
of Proposed Rulemaking, Debit Card Interchange Fees and Routing, in the
Federal Register (NPRM), which sets out proposed rules for implementing
new Section 920. \1\
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\1\ 75 Fed. Reg. 81,722 (proposed December 16, 2010).
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As an executive committee member of the Merchants Payments
Coalition (MPC), RILA has helped to develop the substantial materials
that the MPC has submitted to the Board with respect to the NPRM
including a submission at the pre-rulemaking stage, \2\ a submission on
January 20, 2011, concerning the Board's request for comments on the
fraud-prevention adjustment permitted under Section 920(a)(5), \3\ and
a detailed submission on February 22, 2011, providing views and
recommendations regarding the range of issues set out in the NPRM. \4\
RILA endorses each of the MPC submissions in their entirety, in
particular the most recent comprehensive comment letter. RILA members
have provided substantial expertise and input into the MPC's
submissions, reflecting the wide support from both RILA members and the
broad merchant community.
---------------------------------------------------------------------------
\2\ MPC, Pre-NPRM submission to Director Louise L. Roseman (Nov.
2, 2010), available at: http://www.federalreserve.gov/newsevents/files/
merchants_payment_coalition_meeting_20101102.pdf.
\3\ MPC, Fraud-adjustment submission to Director Louise L. Roseman
(Jan. 20, 2011), available at: http://www.federalreserve.gov/SECRS/
2011/February/20110203/R-1404/R-1404_012011_61804_561400767649_1.pdf.
\4\ MPC, NPRM submission to the Board (Feb. 22, 2011), not yet
available on the Board's Web site.
---------------------------------------------------------------------------
RILA offers the following comments to the Subcommittee in order to
stress the underlying need for Section 920 and the NPRM to address, at
least in part, the fact that the market in which interchange fees are
set for debit and credit cards is fundamentally broken and to stress
that the structure of Section 920 can accomplish the objective of
restoring some needed competition with respect to debit interchange
fees if implemented consistently through the NPRM.
Interchange Fees Are Set in a Broken Market
To place the importance of Section 920 and the NPRM in context, it
is essential to keep in mind how we came to this point, with
interchange fees in the United States today among the highest in the
world. In a functioning market, efficiencies are gained as volume
increases and technology advancements are made. Competition among
parties further ensures that these improvements are translated into
lower costs and/or enhanced services. Yet, as discussed in detail in
the MPC pre-rulemaking submission and the attached report on debit
interchange fees prepared for RILA by James C. Miller III, Ph.D.
(Miller Report), \5\ in the case of interchange fees, the United States
has seen just the opposite. As volume and technology have lowered the
costs of operating the system, the card networks have dramatically
increased interchange rates on merchants year after year. At the same
time, merchants are forced to accept debit cards widely due to the
overwhelming market dominance of Visa and MasterCard, which
collectively controlled 84 percent of the market in 2009. \6\
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\5\ James C. Miller III, ``Addressing the Debit-Card Industry's
Market Failure'', (Feb. 2011)--copy attached.
\6\ Miller report at paragraph 4.
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Networks will claim that vigorous competition exists in the
interchange marketplace, yet this competition is only in order to take
market share away from network competitors by offering card issuers
more generous interchange rates, to the detriment of the businesses,
universities, charities, and even local, State, and Federal
Governments, all of which accept debit and credit card cards for
payment. While governments and utilities generally have the ability to
surcharge debit and credit card users to recoup some of these losses,
\7\ merchants must pass along these costs to consumers in the form of
higher prices, or they must absorb them, which generally results in
reduced services to consumers.
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\7\ For example, the Internal Revenue Service charges a
``convenience fee'' up to several percentage points depending on
whether a credit or debit card is used for such tax payments. See,
Internal Revenue Service, ``Pay Taxes by Credit or Debit Card'',
available at: http://www.irs.gov/efile/article/0,,id=101316,00.html.
---------------------------------------------------------------------------
This drive by the networks to increase interchange rates to the
benefit of card issuers means that the only competition that exists
among the networks is competition to raise interchange fees, unlike the
fierce competition that exists in the retail industry to lower prices
and offer better services to consumers day in and day out. The fact
remains that banks compete every day on a host of products and
services, including interest rates, terms of demand deposit accounts,
etc., but this is not the case with interchange rates. Instead, every
issuing bank agrees to the exact same pricing schedule for exactly the
same product, thereby precluding any downward pressure on interchange
prices.
Steering Toward Less Secure, More Expensive Transactions
For years card issuers have steered customers to less secure, more
expensive payment alternatives. With respect to debit cards, most
issuers only offer rewards points for signature debit transactions,
while some offer double points for signature debit transactions but no
rewards for transactions made using a Personal Identification Number
(PIN) debit transaction. Such efforts to steer consumers away from PIN
debit transactions is particularly perverse since PIN debit is far more
secure than signature debit. In fact, one RILA member reports that the
incidence of fraud on signature debit transactions in its stores is 1
in 9,000 transactions, while the incidence of fraud on PIN debit
transactions in its stores is 1 in 11,000,000 transactions. Even card
issuers acknowledge the inherent beneficial security aspects of using a
PIN, as they require customers using their own automatic teller
machines (ATM) to key in a PIN number rather than using a signature to
authenticate a transaction.
Other banks are far more aggressive in their marketing of less
secure, more expensive signature debit transactions to their customers
versus the use of PIN debit transactions. For example, Pulaski Bank, a
community bank headquartered in St. Louis, Missouri, at one point in
2009 ran a marketing campaign promoting its DreamMiles'
Rewards card, hanging a banner outside of one of its branches that read
``Use your pen NOT YOUR PIN'' (emphasis original), as reflected in the
picture below. \8\
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\8\ Photograph of Pulaski Bank branch signage, Bentonville,
Arkansas (Apr. 27, 2009).
Similarly, CP Federal Credit Union of Jackson, Mississippi,
encourages its customers to ``Use your PEN not your PIN!'' (emphasis
original). \9\ The credit union, which reported assets of just over
$300 million in 2010, qualifying it for the small issuer exemption,
tells customers to ``Choose CREDIT over debit!'' (emphasis original)
and claims that selecting the credit option when prompted is ``safer,
easier and NOW! even more beneficial'' (emphasis original) because the
cardholder is only offered rewards points when making a signature debit
purchase.
---------------------------------------------------------------------------
\9\ CP Federal Credit Union, ATM and Debit Cards general
information (accessed on Feb. 22, 2011), available at: http://
www.cpfederal.com/ASP/Products/product_4_6.asp.
---------------------------------------------------------------------------
Other banks employ ``surcharges'' that are far more direct in their
messaging to consumers: sign for your debit card transactions or else
you will be charged extra for the more secure PIN transaction. Chevy
Chase Bank, which was acquired in 2008 by Capital One Bank of McLean,
Virginia, surcharges consumers an additional $0.50 for transactions
made on a debit card when a PIN is entered, yet the transaction is free
if the consumer signs for the purchase. \10\ Capital One Bank continues
to impose these surcharges for account holders who were previously
Chevy Chase Bank customers.
---------------------------------------------------------------------------
\10\ See, Chevy Chase Bank Schedule of Fees for Personal Accounts
(2009).
---------------------------------------------------------------------------
Finally, the networks themselves steer customers towards less
secure technology through promotions. For example, in recent years Visa
has run promotions on everything from the Olympics, to the Super Bowl
and the World Cup, in which consumers may qualify to win tickets for
life to one of the various sporting events by using their debit cards
for purchases. Upon closer examination of the fine print, however, only
signature debit transactions qualify for the promotions, while PIN
debit transactions do not.
We bring these examples to the Subcommittee's attention only to
show how card networks and card issuers employ a multitude of tools to
steer customers toward less secure, more expensive signature debit
payments, all in an effort to drive the collection of higher
interchange fees. These fees are paid on every purchase with a debit
card by the merchant--and ultimately by consumers overall through
higher prices, whether the purchase is made by cash, check or plastic.
When combined with the fact that Visa and MasterCard have already
rolled out, or are in the process of introducing, more secure chip-and-
PIN technology in the European Union, Australia, Canada and even
Mexico, American merchants are paying among the highest interchange
rates in the world while using inferior 1960s magnetic stripe
technology that increases the fraud costs and chargebacks that
merchants, again, must pay.
New Section 920 Provides Limited, but Essential, Interchange Reforms
Against the backdrop of a broken market for setting interchange
fees and its perverse incentives to maintain a more fraud-prone market,
the reforms adopted by Congress in the Dodd-Frank Act are critically
needed and narrowly tailored to help restore a semblance of competition
with respect to debit card interchange fees. As the Miller Report
concludes:
In the case of interchange fees--and debit interchange fees in
particular--the case for regulatory intervention is strong.
This is truly a case of market failure: networks with monopoly
power over merchants are setting prices for merchants' access
to their networks on behalf of their (frequently overlapping)
card-issuing members, utilizing agreements in which every bank
participating in those card networks agrees to charge merchants
exactly the same interchange fees, regardless of who issued the
card. Thus, regulatory intervention is warranted to provide the
catalyst to return this market to the competitive norm and thus
increase the market's overall efficiency.
The pricing solution chosen by section 920(a) and the Board's
proposed interchange fee standard approximates the pricing
outcome that would obtain in a fully competitive market--that
is, prices based on costs, not demand. \11\
---------------------------------------------------------------------------
\11\ Miller Report at paragraphs 22-23.
We applaud the extensive work that the Board and its staff have
already done to develop the regulations required by Congress in new
Section 920 of the EFTA. While we again commend to the Subcommittee the
MPC's detailed views and recommendations regarding the alternatives and
other issues set out in the NPRM, we stress the following key points
---------------------------------------------------------------------------
from the MPC submission:
With respect to the regulation of interchange fees,
Alternative 1 is preferable, but the safe harbor and cap should
be much closer to the average per-transaction costs of
authorization, clearance, and settlement (ACS), which issuers
themselves report to be no greater than 4 cents and First
Annapolis Consulting reports to be 0.33 cents for PIN debit
transactions (and 1.36 cents for signature transactions).
With respect to the prohibitions on network exclusivity,
Alternative B should be fully implemented by April 2012. As a
transitional measure, Alternative A should be adopted within
three months after the Board issues final rules and network
fees charged to merchants should be capped at current levels
until Alternative B is fully implemented.
With respect to merchant routing, the proposal set forth in
the NPRM that prohibits networks or issuers from directly or
indirectly inhibiting merchants from routing their transactions
should be adopted.
With respect to preventing circumvention and evasion, the
MPC has proposed an amended version of the net compensation
proposal, which would include a general anticircumvention
provision and close remaining loopholes.
With respect to the adjustment for fraud prevention costs,
the MPC has proposed standards drawn from and marrying the best
aspects of both approaches discussed in the NPRM to balance the
interests of issuers and merchants and motivate the
implementation of potentially paradigm-shifting fraud
prevention technologies without prescribing a particular
technology.
The Small Issuer Exemption Will Work
An additional issue that bears particular mention, especially given
today's Subcommittee hearing, is the exemption in the statue that
allows banks and credit unions with assets under $10 billion to
continue to collect the same debit card interchange fees that they
receive today, notwithstanding the new interchange reforms. Section
920(a)(6) of the EFTA states that ``this subsection shall not apply to
any issuer that, together with affiliates, has assets of less than
$10,000,000,000, and the Board shall exempt such issuers from
regulations prescribed under paragraph (3)(A).'' We believe that
Congress was abundantly clear in this language that the limitations on
interchange fees do not apply to small issuers.
Claims by credit unions and banks that such a small issuer
exemption would not work fail to take into consideration the perverse
incentives of the debit and credit card issuance market, in which banks
and credit unions make decisions about whether to issue their cards
under the Visa or MasterCard network based on which company offers them
the highest level of interchange fees. Once Section 920 is implemented,
exempted issuers will continue to make issuing decisions based on which
network offers the highest interchange. Neither Visa nor MasterCard has
any more incentive to lower debit card interchange rates for exempted
financial institutions as a result of Section 920 than either had in
the preceding years. For example, if post-implementation Visa were
hypothetically to lower its rates for exempted institutions, these
institutions would logically migrate to MasterCard because it would
still offer higher rates to attract additional business (and the same
would hold true if MasterCard, for example, were to lower its rate).
Nothing in the Board's NPRM would fundamentally change this incentive
structure for the exempted banks and credit unions. In fact, this
structure is likely the reason for Visa's announcement earlier this
year that it would institute a two-tier rate system for covered and
exempted institutions once the final rules are implemented. \12\ And,
with history as a guide, we anticipate that MasterCard will announce a
similar arrangement in the near future.
---------------------------------------------------------------------------
\12\ First Data has also announced a similar two-tier pricing
structure for its Star PIN-debit network. See, Kate Fitzgerald, ``Two-
Tier Debit Interchange Rate Plan OK With First Data'', ISO & Agent
Weekly (Feb. 10, 2011), available at: http://www.paymentssource.com/
news/first-data-debit-interchange-3005055-1.html.
---------------------------------------------------------------------------
We believe that the concerns of exempted banks and credit unions
with assets under $10 billion are due either to misinformation, or
worse, to scare tactics employed by the card networks to keep exempted
institutions lobbying in opposition to the NRPM. These tactics were
exposed in a recent American Banker article in which Eric Grover, a
payments consultant, was quoted as saying that higher interchange for
small banks and credit unions ``makes total sense'' and that the only
reason that networks did not put to rest unjustified concerns about why
a two-tiered system would work was that it ``was simply intended to
scare credit unions and small banks to keep them lobbying'' against the
overall interchange reforms. \13\
---------------------------------------------------------------------------
\13\ Sean Sposito, ``Visa Plans Two-Tiered Interchange Rates After
Fed Rules'', American Banker (Jan. 10, 2011).
---------------------------------------------------------------------------
In addition to inaccurate claims that the networks will
discriminate against small banks and credit unions, some have asserted
that merchants would also refuse to accept a Visa or MasterCard issued
by a small bank or credit unions. That claim completely overlooks the
so-called Honor-all-Cards rule imposed by the networks, which prevents
merchants from discriminating by issuer, large or small. \14\ In other
words, if a merchant accepts Visa cards, it must accept cards issued by
a single branch community bank with assets under $10 billion and also
any debit cards issued by Bank of America, regardless of the issuer of
the debit card.
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\14\ The Honor-all-Cards rule is one of many network rules to
which merchants are subject. If a merchant agrees to accept Visa or
MasterCard, it must abide by these rules or face the substantial fines
upwards of $5,000 a day. See, Section 5.8.1 of MasterCard's operating
rules at p. 114 at http://www.mastercard.com/us/merchant/index.html;
and Visa's operating rules at pp. 406-407 at http://usa.visa.com/
merchants/operations/op_regulations.html.
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Benefits to Consumers
RILA would like to address head-on the claims by opponents that
interchange fee reforms will only lead to increasing costs for
consumers. If these claims held any validity, then when interchange
fees tripled over the past decade, bank fees would have fallen by a
corresponding amount. Instead, bank fees, too, have exploded during the
same time period. The retail industry is fiercely competitive, with
annual profit margins ranging between 1 percent and 3 percent. With
such a competitive marketplace, retailers have no choice but to pass
along cost savings to consumers. Retailers, after all, are in the
business of selling goods, and in the fiercely competitive retail
market, as the price of retail goods falls, consumers are drawn to the
lowest prices and best service available. Accordingly, retailers will
return savings to consumers by lowering prices, reinvesting in new and
current employees, opening new stores, and offering additional services
to consumers.
Over the past few months, banks have also used scare tactics on
consumers and opinion leaders, blaming the interchange reforms in
Section 920 of the EFTA for the death of free checking. Such
predictions are ungrounded. For example, TCF Bank of Wayzata,
Minnesota, announced shortly after enactment of the statute that as a
covered financial institution, it would have to eliminate the ``free
checking'' services it offers its customers, and replace it with
various service fees to recoup revenue. However, only one month after
proclaiming the death of free checking, TCF Bank announced that it was
reinstating free checking because consumers demanded it. \15\ Other
banks are more upfront about the illusion of free checking, with Bank
of America spokeswoman Anne Pace saying that ``Customers never had free
checking accounts.'' \16\ According to Pace, ``They always paid for it
in other ways, sometimes with penalty fees.'' And, for the small
issuing banks, any impact on free checking is particularly specious
since, as noted above, the statute expressly excludes small issuers for
the limitations on interchange fees imposed by Section 920.
---------------------------------------------------------------------------
\15\ See, Chris Serres, ``TCF Is Putting an End to Totally Free
Checking'', Minneapolis Star Tribune (Jan. 21, 2011), available at:
http://www.startribune.com/business/82255367.html.
\16\ Pallivi Gogoi, ``Say Goodbye to Traditional Free Checking'',
Associated Press (Oct. 19, 2010), available at: http://
finance.yahoo.com/news/Say-goodbye-to-traditional-apf-1888087707.html.
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Any Delay of Final Rules and Implementation Is Unnecessary
RILA applauds the thorough and comprehensive work that the Board
has done in the development of the NPRM, including the surveys of card
issuers, networks and merchant acquirers, on which RILA provided
separate comments. Board Chairman Ben Bernanke's recent remarks that
the Board would be unable to issue final regulations by April 21, 2011,
but that it would meet the statutorily mandated July 21, 2011, for
final regulations to take effect is proof-positive that the Board is
engaged in a thoughtful, fact-based process. Congress should not step
in to interfere with this process and prejudge the final rules which
have yet to be issued by the Board.
Opponents of the reforms have made clear their desire to use delay
of the final rules as a way to thwart and unravel interchange reforms
embodied in Section 920. RILA urges Congress to reject appeals for any
delay in the issuance of the final rules. Doing so would not be in the
public interest and would only allow the card networks and their
issuing banks to perpetuate the broken market with respect to
interchange fees while continuing to collect exorbitant interchange
fees on debit card transactions that bear no relationship to the costs
of processing the transaction.
Conclusion
RILA appreciates the opportunity to submit its views to the
Subcommittee on the importance of Section 920 and its implementation by
the Board rulemakings. The interchange reforms enacted in Section 920
are critically needed and will help restore a degree of competition to
this broken market to the benefit of consumers and merchants, small and
large, across the Nation. RILA and the broader merchant community urge
the Subcommittee to let the Federal Reserve rulemaking process play
out, and we will vigorously oppose any attempts to delay, amendment, or
repeal these essential reforms.
ATTACHMENT
``Addressing the Debit-Card Industry's Market Failure''--Report of
James C. Miller III
A. Background and Expertise
1. I have been asked by the Retail Industry Leaders Association to
offer my opinion regarding the Federal Reserve Board's (Board's)
proposed rules implementing the ``Durbin Amendment'' to the Dodd-Frank
Wall Street Reform and Consumer Protection Act--adding section 920 to
the Electronic Fund Transfer Act (EFTA Act)--from the perspective of
their appropriateness as a regulatory intervention in the market for
electronic payments. In particular, I have focused on the appropriate
policy response to collusive or otherwise parallel conduct by the major
firms in an industry where there is asymmetry between the
competitiveness of buyers and sellers.
2. As set out more fully in my curriculum vitae (Exhibit 1), this
assessment is based on my extensive academic and governmental
experience in the field of Government regulation (and deregulation).
After a career in university teaching and research, I served in the
Reagan Administration as the first Administrator of the Office of
Information and Regulatory Affairs at the Office of Management and
Budget (1981), as Chairman of the Federal Trade Commission (1981-1985),
and as Director of OMB and Member of the President's Cabinet (1985-
1988). Presently, I serve on the boards of several mutual funds and
corporations, such as Clean Energy Fuels Corp., as well as the Board of
Governors of the U.S. Postal Service. I hold a Ph.D. in economics from
the University of Virginia and am the author or coauthor of over 100
articles in professional journals and nine books, including Economic
Regulation of Domestic Air Transport: Theory and Policy (Brookings
Institution, 1974), Reforming Regulation (American Enterprise
Institute, 1980), The Economist as Reformer: Revamping the FTC, 1981-
1985 (American Enterprise Institute, 1989), and Monopoly Politics
(Hoover Institution, 1999).
B. The Debit Card Industry
The existence of market power
3. The major card networks have monopoly power over merchants. In
today's marketplace, merchants have no rational choice but to accept
debit cards when presented by their customers, since the use of debit
cards is so large and growing. Of the over $7 trillion in consumer
expenditures for goods and services in 2009, approximately $1.6
trillion was transacted with debit and prepaid cards (for comparison,
$1.8 trillion was transacted with credit cards and $1.6 trillion with
cash.) \17\ Because of their dominance of the card market, Visa and
MasterCard control the costs merchants pay to accept debit cards as a
means of payment.
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\17\ Nilson Report, Issue 962 (December, 2010), pp. 1 and 10-11.
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4. There are several reasons for this conclusion. First is the
history of development of the two major networks. Both Visa and
MasterCard were organized by large banks and controlled by them. As
they grew, it became increasingly worthwhile for major banks to issue
both networks' cards to their customers. And since the banks controlled
both systems--their representatives sat on the boards of both--it was
only natural that the two card networks would establish schedules of
services and prices that are nearly identical. By 2009, Visa accounted
for 61 percent of all debit-card transactions, MasterCard for 23
percent, and a handful of regional networks for the rest. \18\
Merchants have little choice but to accept cards from at least one of
these two giant networks, and for survival reasons they usually sign
with both. Accordingly, the market for debit card transactions--
vigorously competing merchants on the one side and monopolistic card
networks on the other--is quite asymmetric.
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\18\ Nilson Report, Issue 961 (December, 2010). p. 10.
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5. It is my understanding that over time the two card networks have
charged consistent and increasingly higher interchange fees to
merchants, all of whom are captive and have no countervailing pressure
available to apply. In short, while banks have faced competition in
many lines of their businesses, they have had no difficulty in
monopolizing the market for card acceptance.
6. Moreover, I understand that debit cards were initially provided
by regional networks using PIN authentication and the processing
infrastructure of ATM-networks. These networks charged either zero (at-
par) interchange fees or paid interchange fees to merchants to
compensate them for their investment in PIN pads. After 1990, Visa and
MasterCard began to promote their ``signature'' debit cards, processed
over their credit-card networks. Signature debit interchange fees were
set at the much-higher rates paid for credit-card interchange. I also
understand that, around 1990, Visa purchased Interlink, which was among
the leading PIN debit networks in the United States, and began to
increase its interchange fees. As Visa continued to drive up Interlink
interchange rates, the competing PIN debit networks raised their rates
to maintain levels of issuance under the pricing umbrella created by
Visa. The result has been a convergence of PIN and signature debit
rates. Thus, the level of interchange fees charged for Visa's and
MasterCard's PIN products, and those of the regional PIN networks,
followed an upwards path, despite little evidence of increasing costs
in making such transactions.
7. Monopoly power is also evidenced by the prices established by
the card networks. The pricing schedules of Visa and MasterCard show a
pattern of what economists call ``third degree price discrimination''--
which can take place only if there is monopoly power. \19\ While the
cost of a transaction hardly varies by type of merchant or size of a
sale, the interchange fee does. Grocery stores, for example, typically
pay a low base fee, whereas restaurants and airlines pay much higher
interchange fees. \20\ And the fee increases with the amount of the
sale. It is easy to see that the card networks are establishing
relatively low fees for merchants with relatively high (price-)
elasticities of demand for payment cards, and higher fees for those
with less elastic demands. The same is true with respect to size of
sale: the larger the sale, the less elastic the demand. Again, in a
truly competitive market, sellers are not able to divide the market and
charge different prices to different consumers unrelated to differences
in costs.
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\19\ See, for example, D. Salvatore, ``Microeconomics: Theory and
Applications'' (2003), p. 334.
\20\ See, for example, ``Visa USA Interchange Reimbursement Fees''
(October 16, 2010), p. 2; and (Visa) ``Interlink Interchange
Reimbursement Fees'' (October 16, 2010), p. 2.
---------------------------------------------------------------------------
8. That this form of discriminatory (monopolistic) pricing is the
norm was spelled out recently in Congressional testimony by Visa's
General Counsel: ``Products and services in this economy should be
fairly priced based on the value provided, not some limited concept of
cost, and certainly not on some artificially selected portion of those
costs.'' \21\ Again, in a competitive market, prices are related to
costs, not to the benefits derived.
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\21\ Prepared Statement of Joshua R. Floum before the Subcommittee
on Financial Institutions and Consumer Credit of the House Committee on
Financial Services (February 17, 2011), p. 6; emphasis added.
---------------------------------------------------------------------------
9. While debit-card networks establish very high, monopolistic fees
for merchants, the issuing banks compete strongly for new card
holders--which, of course, leads to more debit-card purchases and more
interchange fee revenue. This competition for new card holders (or
retention of current card holders) takes a peculiar form, however. The
various issuing banks (in alliance with, and incentivized by, the card
networks' schedule of charges) offer cards with extensive benefits.
``Points'' are the ubiquitous benefit--a sort of currency that can be
traded for travel, goods, and even redemptions in cash. I also
understand that special favoritism in the form exclusive offers on
goods is also common.
10. The very existence of this extensive nonprice competition is
itself an indication that the debit-card market is not fully
competitive. If the banks and the card networks were not charging the
merchants monopolistic rates, and instead were charging them truly
competitive rates, the extent of such nonprice competition for
cardholders would be much less. That is, such supracompetitive margins,
built into the current interchange fee schedules, lead to marketing
efforts that tend to ``compete away'' those very margins.
The setting of monopolistic interchange fees
11. The cards networks' rules and procedures make clear that each
card system is the contractual ``hub'' through which their interchange
fees are set--nominally in the best interests of all participants in
the payment system, but actually on behalf of their card issuers.
12. Indeed, Visa's General Counsel has advised the Board that
interchange fees should not reflect the costs of any particular card
issuer, because the networks set fees for all of their issuers. ``We
believe that this approach [implementing the rate model at the network
level] is the most practical and efficient for a number of reasons,
including the fact that the payment card networks currently set the
interchange rates for debit transactions over those networks . . . [and
that] . . . issuers do not in practice set interchange fees; rather,
these fees are set by networks and issuers accept transactions from
different networks.'' \22\
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\22\ See, Letter from Joshua R. Floum to Louise Roseman, Director,
Division of Reserve Bank Operations and Payment Systems, Federal
Reserve Board (November 8, 2010), pp. 13 and 17; emphasis added.
---------------------------------------------------------------------------
13. In turn, once interchange fees are set, under the Visa and
MasterCard rules--which are binding contracts between each network and
its issuers and acquirers--the networks' members use those rates in
their payment card transactions. \23\
---------------------------------------------------------------------------
\23\ See, for example, Visa International Operating Regulations
(Public Version, April 1, 2010), pp. 57 and 961-962; Visa, Inc. SEC
Form 10-K (November 19, 2010), p. 13; and MasterCard Rules, Section 9.4
(October 29, 2010). The rules technically permit issuers and acquiring
banks to enter into bilateral interchange arrangements, but as noted in
paragraph 12, such bilateral arrangements have not occurred in
practice.
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14. Finally, the networks' ``honor all cards'' rules bind merchants
to this result. Once a merchant decides to accept Visa or MasterCard
debit cards, for example, it must accept all debit cards of that type
bearing the network's logo. There is no need for each bank to negotiate
with individual merchants to accept its debit cards. Thus, networks'
current rules enable each debit-card-issuing bank to take advantage of
the network's monopoly power to obtain excessive interchange fees.
15. Deposit accounts are not offered in isolation, but as a means
of generating funds that enable banks to make loans--which, in turn,
provide interest revenue. For example, in the case of checks, the
customer's bank absorbs all the cost of the transaction (except for
fees that may be charged by the merchant's bank for depositing a
check). Banks have traditionally done so precisely because demand
deposits enable the bank to make loans, on which the bank earns
interest, and because the relationship opens opportunities for the bank
to provide other (remunerative) services to the customer.
C. EFTA Act, Section 920
16. I have reviewed Section 920 of the EFTA Act, the Board's
proposed rulemaking implementing that section, \24\ and major
submissions to the Board pursuant to that proceeding. Section 920(a)
requires the Board to establish standards governing debit-card
interchange fees. The statute defines those fees as ``any fee
established, charged, or received by a payment card network for the
purpose of compensating an issuer for its involvement in an electronic
debit transaction.''
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\24\ Federal Reserve Board, Notice of Proposed Rulemaking, 75
Federal Register (December, 28, 2010), pp. 88722 et seq.
---------------------------------------------------------------------------
17. The scope of price intervention required by the statute is
narrow: it does not address prices charged by an acquiring bank for its
role in processing the merchant's debit-card transactions, nor does it
restrict the fees that a card network may charge acquiring and issuing
banks for its role in processing such transactions (except to prevent
evasion of the interchange fee standards). As I will discuss below,
this limitation on the Board's regulatory power is appropriate, as such
additional constraints are not needed to accomplish the objective of
making the card market more competitive. By its terms, the statute does
not address independent action by a debit-card issuer to charge
transactions fees directly to merchants (possibly through the
merchant's acquiring bank) when one of the issuer's cardholders
purchases goods or services from the merchant, leaving such
transactions to the ordinary forces of competition. This competition
could take many forms and would be based on rivalry among individual
card issuers (without reliance on networks or honor-all-cards rules) to
gain acceptance of that card as a payment mechanism at individual
merchants. There would be no need for regulation to limit fees that
might be charged as a result of interaction between individual
merchants and individual issuers, as long as those fees are transparent
and are subject to the discipline of market competition. Thus, in such
a competitive environment, there would be no need for regulators to
specify what costs such fees might or might not recover.
18. In contrast, section 920(a) addresses fees collected by debit-
card issuers when those fees are charged by or through a network, thus
enabling an issuer to utilize the network's market power. In this
regard, while subsection 920(b)(2) gives merchants the right to provide
discounts and other incentives for differing forms of payment--cash,
checks, debit cards, or credit cards--it is my understanding that the
``honor-all-cards'' requirements of Visa and MasterCard, for example,
will continue to require nondiscriminatory acceptance of cards from
every issuer of the relevant type of card offered by the card network.
19. Section 920(a) simply ensures that when debit-card issuers rely
on card networks' market position to obtain compensation from merchants
as a result of card acceptance, the level of those fees are not set at
a supracompetitive level but are ``reasonable and proportional'' to the
card issuers' incremental costs for authorization, clearance, and
settlement of those transactions.
20. Importantly, Section 920(b)(1) sets in motion potential longer-
term structural reform by (a) ensuring that card issuers offer multiple
networks for the routing of debit-card transactions for each type of
card authorization method, and (b) giving each merchant the ability to
direct and/or prioritize the choice of network to be used in a debit-
card transaction. To the extent that these provisions are implemented
in an effective and timely manner, networks may, arguably for the first
time, compete on price for merchants' business.
D. An Appropriate Response to Market Failure
21. Throughout my career I have been a consistent skeptic about the
ability of Government intervention to improve the functioning of the
marketplace. But sometimes a free market does not--or for any number of
reasons cannot--correct a divergence from the competitive norm. The
persistence of such divergences over time, uncorrected by unencumbered
economic forces, is among the few scenarios in which I believe there is
reason for Government to examine and possibly correct the underlying
cause.
22. In the case of interchange fees--and debit interchange fees in
particular--the case for regulatory intervention is strong. This is
truly a case of market failure: networks with monopoly power over
merchants are setting prices for merchants' access to their networks on
behalf of their (frequently overlapping) card-issuing members,
utilizing agreements in which every bank participating in those card
networks agrees to charge merchants exactly the same interchange fees,
regardless of who issued the card. Thus, regulatory intervention is
warranted to provide the catalyst to return this market to the
competitive norm and thus increase the market's overall efficiency.
23. The pricing solution chosen by section 920(a) and the Board's
proposed interchange fee standard approximates the pricing outcome that
would obtain in a fully competitive market--that is, prices based on
costs, not demand. Further, the relevant costs identified in the
statute and incorporated by the Board in its notice are those costs
that I understand are directly incurred in processing each transaction:
the costs of authorization, clearance, and settlement. \25\
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\25\ See, Federal Reserve Board Notice, ibid., pp. 88722 and
88735. I realize that the Board is undertaking a separate rulemaking
regarding an adjustment for issuer-specific fraud prevention costs
using the statutory considerations for such an adjustment, but that is
beyond the scope of my report.
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24. Most significantly, section 920(a) requires regulation only of
debit-card interchange fees established by payment card networks.
Issuers are free to charge fees for card acceptance negotiated directly
with merchants as long as the imposition of these fees is not
characterized by market failure, including network honor-all-cards
rules. Thus, the proposed regulations appear to be consistent with both
the limited mandate of section 920 and the policy prescriptions
embodied in that provision.
25. It is also notable that the regulatory scope of Section 920 is
narrow. It does not regulate any fees that a debit issuer imposes
individually and directly (rather than through a network) on merchants
or other parties. There should be no market failure associated with
such issuer-specific fees as long as they are subject to the discipline
of market competition. It is appropriate, therefore, that Section 920
was drafted to leave such fees unregulated under those conditions.
26. Finally, the rules proposed by the Board to implement
subsection 920(b)(1) to provide multiple network options on a card and
to mandate merchant selection of network routings, promise a longer-
term marketplace solution. If implemented to require at least two
network choices for each PIN and signature method of authorization,
there should be a meaningful increase in competition among issuers. By
choosing the lower-cost option, merchants could force issuers and card
networks to reduce their interchange and network fees--perhaps making
the regulation of fees no longer necessary, once competition were
firmly in place.
EXHIBIT 1