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Updated Oct 20, 2023

When Community Banks Die: How Small Businesses Are Affected

Community banking can be a great small business funding resource if national options don't fit your needs. So what does its decline mean for small businesses?

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Matt D'Angelo, Business Operations Insider and Senior Writer
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When it comes to financing, community banks have been providing support to small businesses for decades. However, a problem is emerging that’s affecting small business: Community banks are closing and consolidating due to pressure from regulation and an uneven lending playing field. Here’s what to know about how the decline in community banking might affect your small business. [Considering funding for your business? Read our guide on how to get a small business loan.]

What is community banking?

A community bank is an institution that caters to a smaller, local audience rather than the large national audience of larger banks. These banks typically develop close relationships with their customers, and this personal connection is often a selling point for community banking. 

Notably, there’s no one accepted size that defines the term “community banking.” In general, though, a community bank has just a few branches, all of which are located in the same city.

Key TakeawayKey takeaway
There's no formal size range for community banks. More important is that the bank serves a local audience.

Why is community banking important for small business funding?

The personal connections underlying community banking can be highly meaningful for your business. Namely, if you need a loan but can’t meet traditional bank credit score criteria, community banks might be more willing to help you out. 

The positive impacts of community banking can extend beyond your business to the entire local economy. If a community bank in your area regularly offers loans to many businesses, it’s effectively funding small businesses. That means you can directly trace local economic growth to community banking. Plus, since community banks often know their neighborhoods and the people in them quite well, they can more quickly consider and approve loan applications.

Key TakeawayKey takeaway
Community banks are an important small business funding source when other options are unavailable.

The history of community banking

Community banking is far from new. In fact, its history is interwoven with the story of how the American economy first came to thrive. 

“The success of the American economy was built in part on the backs of small businesses that were financed by small banks,” said Stephen Andrews, former president of a few community banks based on the West Coast. “Removing the community banks from the equation upsets and diminishes the potential of small business to compete effectively.”

However, in recent years, the prevalence of community banking has decreased. One event may be to blame. 

The modern-day presence of community banking

When the 2008 financial crisis hit, the U.S. government responded with a bank bailout and increased regulation. In Washington’s eyes, it was time to hold Wall Street accountable and stop any future economic turmoil that could be spurred by big institutions. But the reach of the Dodd-Frank Act, Washington’s answer to the 2008 crisis, extended beyond the big banks on Wall Street. Local community banks suddenly had a whole host of regulations to adhere to.

“The sins of big banks brought on a crush of new regulations with Dodd-Frank legislation that disproportionately impacted smaller community banks,” Andrews said. “Community banks were forced to invest in new software, technology infrastructure, and compliance personnel, creating an unavoidable high level of fixed costs that are disproportionate to larger institutions.”

But Dodd-Frank is just the tip of the iceberg for an area of banking that’s been on a slow decline for decades. Between 1994 and 2015, community banks’ share in bank lending and assets fell by 40%, according to a Harvard Kennedy School study on the state of community banking in 2015. 

In recent years, that trend has continued. In Q3 of 2021, for example, there was a net reduction of 130 community bank charters, leaving only 4,752 community banks active nationwide, according to a report by Banking Strategist.

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Why community banks are going away

Regulation is a big part of community banking’s decline, but it’s only one factor that has led to the erosion. The emergence of fintech lenders, tax considerations for credit unions and the pressure to consolidate has affected community banks, according to Andrews.

All these factors contribute to an uneven playing field for community banks. They’re being regulated like big banks, taxed like big banks and other lenders can provide the same services to small businesses without having to jump through the same hoops. Credit unions, for example, enjoy a different tax structure compared to traditional banks. However, lending practices from credit unions have begun to mirror community banks. Some credit unions enjoy the same functionality as a community bank without the tax or regulatory burdens.

“Credit unions are walking and talking like banks,” Andrews said. “And while their powers to lend to small businesses have expanded, the playing field is not even with respect to credit unions, as they enjoy taxation advantages that community banks do not enjoy. And this situation translates to a tax-advantaged pricing advantage.”

How fintech affects community banking

Community banks are going away: They’re consolidating, being purchased by big banks and closing. As the community banking market erodes, small businesses are being squeezed. Businesses that can’t meet conventional lending requirements from big institutions are having to turn to fintech lenders, which often charge higher interest rates on shorter terms compared to what a community bank could offer.

“Small businesses suffer to a degree financing with a fintech player,” Andrews said. “If they do fit the [lender’s] criterium, they would likely pay a premium finance rate versus the rate a community bank would have charged.” 

Fintech lenders – online lenders that boast next-day approvals and automated underwriting processes – provide the same services as banks but don’t have to endure the same crushing regulations that community banks need to.

“On the regulatory side, there has been the rise of fintech that does not receive the same scrutiny as banks with respect to oversight,” Andrews said. “This creates an operating price disparity and compliance disparity favoring the new market entrants.”

In addition to an uneven playing field, banks are suffering from a talent gap, according to SBA lending consultant and BOLD Lender president Alex Espinosa. He said that generational changes within community banks are encouraging older bank presidents to take buyouts and consolidate as opposed to giving the keys to inexperienced executives. He also said that the best and brightest minds are likely working for technology companies as opposed to banks.

These factors have slowly chipped away at the community banking market for ye2ars, and its demise is hitting small businesses the hardest. [Related: SBA Loans vs. Conventional Loans]

How small business is affected by the decline of community banks

Community banks provide 77% of agricultural loans and over 50% of small business loans, according to the Harvard Kennedy School study. What community banks offer small businesses in the lending process is almost intangible – because banks know the community, they’re able to provide loans to businesses based on information that isn’t just found in a business’s finances. Learn more about how to manage your business’s cash flow.

Instead of meeting rigid requirements through a fintech lender or going to a large, conventional bank to be denied because of shaky financials, small businesses can turn to a local community bank to get the funding they need at an acceptable rate. Because the bankers are rooted in the community, they can consider additional factors regarding a borrower’s situation that go beyond basic financial data.

Community banks are more personal, and they provide more informed loans as a result. According to the Harvard Kennedy School study, default rates on family real estate loans with community banks was 3.47% in 2013. In the same year, larger banks experienced a default rate of 10.42%.

“Community banks generally are relationship banks; their competitive advantage is a knowledge and history of their customers and a willingness to be flexible,” the study reads.

Where can small businesses go for funding without community banking?

Community banking’s decline has a direct impact on small businesses. With fewer and fewer community banks to turn to for financing, small businesses have to work with bigger banks or fintech lenders. It can be hard to get approved with a bigger bank, and fintech lenders generally have higher interest rates and shorter terms than conventional bank loans.

The business that’s hurt the most in all of this is the one that doesn’t meet the needs of fintech lenders or big banks.

“Those businesses that require personal, labor-intensive attention from a credit underwriting perspective for loan approval will not fit the automated underwriting process,” Andrews said. “Community banks … capture borrowers that don’t have cookie-cutter financing requirements.” [Read related article: The Best Small Business Government Grants]

Will this problem be solved?

Andrews said major changes need to happen with taxation and regulation. Relaxing legislation that was intended for big banks will allow local banks to breathe again. Adjusting tax practices on credit unions will also help level the playing field for community banks.

“Community bankers are not afraid of competition or market disruption, but they do want the playing field balanced as it relates to taxation and regulatory burden,” Andrews said.

Espinosa agreed, saying that regulation needs to be changed so community banks have a chance to be competitive. Whatever the right course of action is, community banking is in decline, which means small businesses may not be able to get the financing they need.

Max Freedman contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.

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Matt D'Angelo, Business Operations Insider and Senior Writer
Matt D'Angelo has spent several years reviewing business software products for small businesses, such as GPS fleet management systems. He has also spent significant time evaluating financing solutions, including business loan providers. He has a firm grasp of the business lifecycle and uses his years of research to give business owners actionable insights. With a journalism degree from James Madison University, D'Angelo specializes in distilling complex business topics into easy-to-read guides filled with expertise and practical applications. In addition, D'Angelo has profiled notable small businesses and the people behind them.
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