Will America’s Smaller Banks Die – And Should They?

“Try getting this kind of help at Home Depot or Lowe’s.”

The clerk was right. I couldn’t. Fischer Hardware was a local Washington, DC-area mini-institution because it stocked everything, and its clerks knew everything.

Its customers couldn’t live without its old-fashioned, high-touch service.

Until they could: A decade into the Big Box era, Fischer Hardware was out of business.

From theft to bartering to haggling at open-air markets to storefronts to walkable Main Streets to shopping malls to strip malls and Big Box stores to e-commerce, retail has always been evolving.

Does anyone have a reason why banking won’t evolve, too?

Disclaimer: I don’t know the future. I can point out a trend that’s already in place, but regulatory changes and factors like interest rates could derail the trend. I’m also trying to look objectively, but I realize that people working at small banks may not like what I’m saying (and they likely know a lot more than I do).

But crises speed evolution, and in the wake of both Silicon Valley Bank’s blowup and the mini banking crisis that it spawned, I think it’s fair to ask:

Will small and regional banks survive?

And – with due respect – do we really need them? Banking, especially fractional reserve banking, where banks only keep a minority of their deposits on hand, is about trust. Increasingly so.

In the trust vacuum following Silicon Valley Bank’s implosion, depositors are flocking to the safety of the US’ too-big-to-fail banks: Bank of America
BAC
added $15 billion in deposits in a matter of days, per Bloomberg. That’s less than 1% of its $2 trillion in total deposits, but big banks’ deposit gains are small banks’ deposit losses.

How safe are bank deposits?

In “America Needs Its Small Banks,” an op-ed for The Wall Street Journal, Kevin R. Greene and John Michaelson, CEO and director, respectively, of blockchain-for-banks provider Tassat, make the case that America needs its smaller banks in large part because 60% of small business loans and 80% of farm loans come from them.

I’m sympathetic to small banks and to liking small banks, but this is like saying the car wouldn’t replace the horse because 80% of miles are traveled by horse.

Cars didn’t immediately replace horses, and big banks aren’t immediately replacing small banks. But the trend since the early 1980s is clear – and perhaps reminiscent of the horse phase-out.

Why? One reason — and remember, since the early 1980s, the US has seen relatively low interest rates — is consolidation; most of the disappearing banks didn’t fail; they were gobbled up. Banking is about trust, but it’s also about scale – and they go together, especially in a too-big-to-fail world.

Consolidation gives customers better pricing and more options. People lament that Walmart
WMT
gutted the mom-and-pop Main Street character from America, but they still shop there.

Yet even with this decline, the US still stands out for having spades of mom-and-pop banks. How many will remain in 20 years?

(If you’re curious, the 27-country EU collectively sports 5,000 banks or credit institutions, but like the US, its counts are precipitously falling by the year.)

Granted, markets dominated by a small number of big banks need watchful regulators to prevent price-gouging. And whether it’s Main Street’s charm, Fischer Hardware’s service or mall-queen bangs, evolution has a price. The frizzy bangs of the 1980s disappeared, but the customers of those dying companies didn’t. They just went to Home Depot, Walmart and Amazon
AMZN
.

Switching banks is harder than switching hardware stores. But is 60% of small business lending – or even a material piece of that 60% – really at risk of disappearing if we stop giving smaller banks a partial free pass on the regulatory standards we hold systemically important banks to?

Thanks to 2018 Dodd-Frank rollbacks – rollbacks Silicon Valley Bank and others spent millions of dollars lobbying for – the bar at which many of the rigorous Dodd-Frank liquidity, capital adequacy, and stress test requirements kick in was raised from $50 billion in assets to $250 billion.

Small towns often have (or establish) zoning laws to protect mom-and-pop Main Street stores from Walmart. But it’s one thing to protect stores selling custom jewelry and dog sweaters from homogenization, whereas banking’s product is a commodity. Yet even with a partial free pass – one that hurts the rest of the industry (and its customers) who have to bail failing banks out – smaller banks, statistically speaking, struggle to outcompete their bigger brothers.

Both small and specialty banks do earn higher yields on assets than bigger banks (see page 10 of this FDIC report), but small bank efficiency ratios, a metric where lower is better, are roughly 10 percentage points worse than bigger bank ratios, and specialty banks are three times more likely to be unprofitable than big banks.

A smaller bank apocalypse will cause unfortunate collateral damage, especially in specialty demographics: Silicon Valley Bank took great care of its startup customers and even made loans based on potential fundraising ability, which a Big Box bank would presumably never do.

But as we’ve seen in recent weeks, banks that over-concentrate in a particular demographic (startups) or speciality (crypto) are taking more risk than more diversified banks.

Likewise, I’m not saying a nation dominated by fewer banks is entirely a good thing. I’m just saying that in an industry where scale and safety are evolving into the predominant success factors, it may be inevitable.

James Early is the Chief Investment Officer of digital investment platform BBAE.