[Senate Hearing 112-77]
[From the U.S. Government Publishing Office]





                                                         S. Hrg. 112-77


      THE STATE OF COMMUNITY BANKING: OPPORTUNITIES AND CHALLENGES

=======================================================================

                                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









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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

                              ----------                              

                        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

                              ----------                              


                        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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \2\ Noncurrent loans are loans that are 90 or more days past due 
or have been placed on nonaccrual status.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
     \2\ Hein, Scott E., Timothy W. Koch, and S. Scott MacDonald, ``On 
the Uniqueness of Community Banks'', Economic Review (First Quarter, 
2005).
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
     \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\
---------------------------------------------------------------------------
     \1\ 75 Fed. Reg. 81,722 (proposed December 16, 2010).
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
     \5\ James C. Miller III, ``Addressing the Debit-Card Industry's 
Market Failure'', (Feb. 2011)--copy attached.
     \6\ Miller report at paragraph 4.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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\
---------------------------------------------------------------------------
     \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.
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    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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \18\ Nilson Report, Issue 961 (December, 2010). p. 10.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
     \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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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.''
---------------------------------------------------------------------------
     \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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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



