Community Banks, Part Three

This morning, Simon asked why community banks seem to be opposing the Consumer Financial Protection Agency. Felix Salmon agrees that community banks should be in favor of the CFPA, for three reasons: (1) the CFPA should increase the cost of complexity, not the “boring banking” that community banks are typically thought to do; (2) the CFPA should level the playing field with predatory lenders, saving community banks from the choice of losing market share or becoming predatory lenders themselves; and (3) the CFPA should shift competition from finding hidden ways to gouge customers to traditional underwriting, which should be a community bank strength. He later adds (4) the big banks’ big advantage is in deceiving customers, which the CFPA should be able to rein in.

Salmon thinks there are still two reasons why community banks may be afraid of the CFPA:

I think it’s a combination of fear of the unknown, on the one hand, and fear of the big banks, on the other. Since every regulator to date has been successfully captured by Wall Street, it’s reasonable to assume that the CFPA might end up being captured by Wall Street too. In which case the burdens of the CFPA might end up being borne disproportionately by smaller community banks.

The commenters on Simon’s post made some similar points, beginning with Bond Girl – “I know several executives at small banks that were flipping subprime mortgages and the like” – and Russ – “it’s not irrational for the smaller banks to fear that in practice regulation would be gamed to further empower the big banks while falling on the backs of the smaller.”

I think it breaks down this way. To the extent that community banks were ripping off customers with mortgages they had no chance of repaying (if Richard Posner or Peter Wallison is reading this, replace everything from “ripping” to “repaying” with “helpfully giving customers the option of rationally speculating on housing prices”), then that is something that should stop, and the CFPA should be aimed against them. Put another way, if that is the case, then community banks should be ignored on this issue just like Angelo Mozilo should be ignored.

That said, I think there are probably many community banks that do fit the “boring banking” stereotype. When I bought my family’s house, I got a mortgage from Greenfield Savings Bank, based in Greenfield, Massachusetts, which, I believe, did not even reserve the right to resell my mortgage. Looking at their current rate sheet, I see that they offer 15-, 20-, and 30-year fixed-rate mortgages; a 5/1 adjustable-rate mortgage; and 30- and 40-year fixed-rate mortgages for first-time homebuyers. And that’s it.

The first question to ask about these banks is: if size is so important in banking (I’m thinking of all those people who say that breaking up mega-banks would hurt consumers or, worse, the entire country), then why does Greenfield Savings even exist? Community banks must have some source of competitive advantage over Bank of America and Citigroup. There are two obvious possibilities. One is that customers prefer dealing with local banks, and based on my personal experiences, the level of customer service is far superior than what you get with a megabank. The other is that community banks, as Salmon said, are better at underwriting, because they actually know the characteristics of the neighborhoods they are underwriting in and, possibly, the borrowers they are underwriting. The reason I went with Greenfield Savings was that they offered me a lower rate than any national bank, and presumably they were able to do this because they knew something about the local market that the national banks didn’t.

Now, both of these are advantages that should be protected by the CFPA. That is, if your goal is to provide better customer service, you are probably not in the business of screwing your customers. And if your competitive advantage is in underwriting, then you have no need to confuse customers with unnecessarily complex products. You should be happy that Elizabeth Warren is keeping predatory lenders out of your backyard, because even if you refuse to match their mortgages, they are driving up housing prices and making it harder for you to find qualified borrowers.

(On the other hand, if you decide that your strategy is to originate toxic mortgages and flip them to investment banks, then you have no competitive advantage left and no business to go back to when demand for your mortgages craters, and no one will bail you out because you are too small.)

So we are left with Russ’s problem: small banks believe that once the CFPA is created, it will be captured by big banks, who will use it to screw them – not an irrational fear, given the way regulation is often used as a stick with which one set of corporate interests beats on another. But the simple answer there is that Tim Geithner and Michael Barr (and Barney Frank) need to design the CFPA in such a way as to minimize this possibility. Maybe they could have rules requiring the CFPA to allocate auditing resoruces in some proportion to firms’ size. Maybe they could slap special anti-lobbying provisions on the CFPA (high salaries but no ability to work for a company you regulated for a long time) to reduce the risk of capture. Maybe they could put in a tax-and-transfer mechanism to ease the compliance costs for small banks. Maybe something else.

The bottom line is, either community banks are just as guilty as the unregulated mortgage brokers and the investment banks that funded them, in which case Geithner et al. need to make the case that Congress should not listen to them; or community banks are part of the solution, in which case Geithner et al. need to make the case to them that they should support the CFPA. I obviously support what Geithner is trying to achieve with the CFPA. But it’s time to close the deal.

Originally published at The Baseline Scenario and reproduced here with the author’s permission.

One Response to "Community Banks, Part Three"

  1. Dick Ginnold, Guest   August 7, 2009 at 7:48 am

    Why don’t you look at the potential of Credit Unions. They are member controlled and probably have a much smaller default rate than banks. Laws have broadened the criteria for belonging. Generally they have stayed away from derivatives and hold a large portion of their lending. Their lending rates are low and their CD rates are competitive. I am sure they have lower costs than commercial banks. I recently retired and am not taking many financial risks but was in private business. There were difficult times in the past 20 years that my credit union loan officer saved my rear.I have been a member of two large Oregon credit unions for a long time