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.
"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, a 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."
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 Dodd-Frank, Washington's answer to the 2008 crisis, extended beyond just the big banks on Wall Street. Local community banks suddenly had a whole host of regulation 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 percent, according to a Harvard Kennedy School study on the state of community banking in 2015.
Community banks are going away – they're consolidating, being purchased by big banks or just 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 verse the rate a community bank would have charged."
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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 and while their powers to lend to small businesses have expanded," Andrews said. "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."
The uneven playing field extends into the FinTech space as well. 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 author Alex Espinosa. He said generational changes within community banks are encouraging older bank presidents to take buyouts and consolidate as opposed to giving the keys to an inexperienced executive. He also said 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 years, and the demise is hitting small businesses the hardest.
How small business is affected by the decline of community banks
Community banks provide 77 percent of agricultural loans and over 50 percent 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.
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 the 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, in 2013 default rates on family real estate loans with community banks was 3.47 percent. In the same year, larger banks experienced a default rate of 10.42 percent.
"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.
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 more higher interest rates and shorter terms compared to 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 offer and capture borrowers that don't have cookie cutter financing requirements."
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. Regardless of what the right course of action is, community banking is in decline, which means small businesses can no longer get the financing they need.