Narayana Kocherlakota: The current and future state of community
banking
Speech by Mr Narayana Kocherlakota, President of the Federal Reserve Bank of
Minneapolis, to the Independent Community Bankers of Minnesota, Brainerd, Minnesota,
15 August 2014.
* * *
Thanks to Ron Feldman, David Fettig, Terry Fitzgerald, Paul Schreck and Sam Schulhofer-Wohl for their
assistance with these remarks and the supporting materials.
I want to thank Marshall and other ICBM officers and members for inviting me to your annual
conference. I appreciate the opportunity to share my views on community banking with all of
you, but just as importantly, I look forward to your questions and our discussion following my
talk. Today I will talk mainly about the state of community banking, especially here in
Minnesota, and I will conclude with some thoughts on the country's economic performance.
Before I begin, just a reminder that the following views are my own and not necessarily those
of my Federal Reserve colleagues.
This pairing of community banking and economic performance is natural and important. What
happens in Main Street credit markets has a significant influence on the broader economy.
Community banks are an essential credit provider for Main Street. Community banks have
the skills and knowledge to evaluate borrowers who, because of their size, activity or
location, are relatively costly for an outside firm to evaluate. As a result, community banks
facilitate beneficial economic activity that would not otherwise take place. The individuals and
businesses receiving credit from your banks are key components in both local and national
economies; they produce valuable output and provide numerous jobs. As I will describe later,
these are central concerns of the Federal Reserve as we seek to promote maximum
employment and price stability.
I will make my four main points on the state of community banking.
 Community bank recovery from the financial crisis has been strong with regard to
asset quality, but earnings and loan growth have lagged.
 Lagging earnings and loans have raised questions about the cost of new, post-crisis
supervision and regulation.
 Low earnings and higher regulatory costs have also raised concerns about
community bank consolidation and its potential acceleration.
 In response to these concerns and as a matter of prudent public policy, I strongly
support "tailoring" supervision and regulation to reflect the risks and roles of
community banks.
I will now describe these issues in more detail.
Community bank conditions
Community banks in Minnesota and the nation experienced a very sharp increase in problem
loans during the financial crisis. Fortunately, that trend has now reversed.
Consider a standard measure of problem loans: the ratio of noncurrent and delinquent loans
to bank capital and the allowance for loan loss. In the first quarter of 2009, that ratio rose for
all loans to 24 percent for the median Minnesota bank, double the 25-year median level of
12 percent. For commercial real estate loans, the problem loan ratio rose to about 9 percent,
nine times higher than the 20-year median of 1 percent.
The problem loan story has changed completely. The ratio for total loans is at 9.5 percent for
the median Minnesota bank, right around the 25-year low. And the ratio for problem
commercial real estate loans for the median Minnesota bank is at 2 percent and rapidly
returning to pre-crisis levels. These same general patterns hold for the nation's banks.
The low earnings and negative loan growth for the median Minnesota bank have also
improved, but not yet to pre-crisis levels. Return on average assets, a standard measure of
profitability, has been holding very steady for the past several years at just below 1 percent.
This is clearly better than the trough of 0.5 percent during the crisis. But the 20-year median
is 1.15 percent. Currently, the return on average assets of the median Minnesota bank is at
0.94 percent, which is at the 19th percentile for the past 20 years.
Year-over-year net loan growth for the Minnesota median bank is at 4.6 percent. Again, this
is much better than the -4.7 percent crisis trough; indeed, negative growth persisted through
the end of 2012. But the 25-year median is nearly 6 percent for Minnesota banks, while
4.6 percent is at the 39th percentile. The nation's banks show similar general patterns.
So, yes, there has been recovery in important ways for community banks in the state. But
other important measures continue to lag historical norms more than five years after crisis
depths. This weaker-than-hoped-for performance is one factor raising concerns for
community banks about the additional supervision and regulation burden that faces them
post-crisis. I'd like to turn to those concerns now.
Post-financial crisis supervision and regulation of community banks
Low earnings levels have many potential sources. Let me mention three. First, on the
revenue side, weak loan growth naturally leads to more competition for available loans and
drives down returns. Second, if banks can't make more loans, they typically replace loans
going off their books with securities. But securities usually earn less than loans, lowering
bank returns. Finally, interest rates are at very low levels, and that compresses bank
margins.
Higher costs can also reduce bank earnings, and it is clear that the costs of complying with
bank regulation and supervision are increasing. Since the financial crisis, and the 2010
Dodd-Frank Act, supervision of community banks and the entire banking sector has become
more intense. This is not a transitory change reflecting weak asset quality. Instead,
supervisors have recalibrated risk management expectations broadly for community banks. I
see higher expectations continuing to spread across bank operations. Meeting these
expectations will increase bank costs.
To what extent has additional supervision and regulation raised costs, reduced earnings and
shrunk profits? This is difficult to answer with precision, but analysis at the Minneapolis Fed
indicates that reductions to profitability could be material, particularly for the smallest
community banks. Our estimates suggest, for example, that the median reduction in return
on assets for banks with less than $50 million in assets would be 14 basis points if they need
to increase staff by half a person, and 45 basis points if by two employees.1
Reduced returns on assets can encourage capital to flow from the banking industry. And,
indeed, bankers routinely raise concerns with me about the potential for more regulation to
drive consolidation in the industry, a topic to which I now turn.
Community bank consolidation
The number of community banks in Minnesota has been falling for some time. There were
341 banks chartered in Minnesota as of the first quarter of 2014, down from a peak of 760 in
1980. As noted, many are concerned that the rate of decline will rise as increased
supervision and regulation depresses earnings. Many bankers also tell me about intangible
costs, arguing that some new compliance requirements distract from serving customers.
These soft costs could also drive bankers to exit the industry.
My concern is with the public policy aspect of this matter. It is possible that the evolution of
information technology may have increased the returns to scale in banking. As a society, we
should expect and indeed welcome consolidation as a response to this natural economic
force. But there is a policy concern if negative benefit/cost regulation or supervision drives
out banks that would otherwise effectively serve customers.
To help determine if new regulations and supervision introduced since the financial crisis
have led to more rapid consolidation, the Minneapolis Fed is estimating future consolidation
of banks in the United States and Ninth District states based on historical trends. If
consolidation exceeds projected rates, that might suggest that new supervision and
regulation has changed the dynamics of banking. So far, however, the rate of recent
consolidation of Minnesota community banks has been consistent with historical patterns.
We continue to monitor consolidation rates relative to forecasts in order to be able to detect
changes that are not readily attributable to technological forces. Our website contains
quarterly updates of these forecasts.
But both bankers and policymakers are concerned about the long-term health of community
banking, not just next year's numbers. How many community banks will exist in 10 years? Of
course, I cannot answer this question with certainty, but I can offer a few perspectives. If
historical patterns continue, the number will fall considerably. There will be just 263 banks in
Minnesota in 2024, a 23 percent decline from 341 currently, assuming that consolidation over
the next 10 years continues the trend seen over the past 30. Or we could assume a slower
rate of consolidation, like the 14 percent decline from 1995 to 2005. That would put the
number at 293 community banks 10 years from now.
This is an admittedly crude modeling approach. We have also constructed a more elaborate
statistical model of the potential long-run decline in the number of banks in Minnesota. Our
statistical model is based on the historical movement of banks into, and out of, different asset
groupings. Some banks get larger and move from one size bucket to another, while other
banks exit the industry altogether. This transitional model - which we use to forecast the
number of banks in Minnesota one year out on our website - suggests that the number of
banks in the state will fall to 282 in 10 years.
I've discussed three different estimates. They all predict that the number of banks in
Minnesota will fall sharply over the next 10 years - from the current 341 to a number in the
high 200s. By way of comparison, the median decline in the number of banks for all states
across all 10-year periods since 1985 is 25 percent, a bit higher than some of the estimates
we provided.
To be clear, these forecasts are only estimates. They should be interpreted accordingly. The
actual number of banks may turn out to be smaller - or, indeed, it might turn out be larger.
Tailoring community bank supervision
I've already noted that it is a matter of considerable public policy concern if regulations, not
market forces, are important causes of bank consolidation. Federal Reserve policymakers
have recently discussed how better tailoring of supervision and regulation to community
banks can be helpful in reducing the extent of this problem.2 The Federal Reserve does some
tailoring already, but I think we should do more. I'll mention two examples of the kind of
tailoring that I have in mind. I'll then turn to two additional steps we might consider.
On safety and soundness, the Federal Reserve and other agencies received excellent
comments from community banks on the Basel III proposal. These comments led to changes
to the proposed rule that reduce unnecessary burdens on smaller banks.3 Smaller banks can
opt out from having their capital levels vary due to changes in particularly volatile aspects of
income. The final rule also allows smaller institutions to continue to count certain types of
stock or securities as capital, when larger banks cannot. I think the rule-making process
worked well in this instance. Issuing a preliminary rule and receiving comments from bankers
allowed the final regulation to better address the actual risks posed by community banks.
On the consumer side, the Federal Reserve has moved to a more risk-focused exam
process, from the less flexible previous approach. The new framework allows our examiners
to better tailor their exams to the consumer risks that a particular bank may actually pose.
Many banks that the Minneapolis Fed supervises do not engage in activities that pose a high
risk to consumer protection. And many also have a strong, documented record of compliance
and relatively little change in operations. Under the new framework, examiners can more
readily eliminate certain areas of review.
The benefits of the new consumer program go beyond a more focused scope. The new
framework encourages more of our supervisory work to occur off-site, thereby reducing the
on-site burden we put on community banks. At the same time, where there are potentially
risky activities, the new framework allows for a deeper dive.
In sum, I think the new consumer exam framework epitomizes the tailoring we need. It's
based on an analytical approach aimed at improving supervision, and it also captures
institution-specific details where appropriate.
Where can we engage in additional tailoring? Governor Daniel Tarullo has noted potential
benefits in reviewing statutes that apply new regulations to all banks. Community banks may
not create the risks that a specific regulation addresses. In that vein, he noted the so-called
Volcker rule and Dodd-Frank incentive compensation requirements. I strongly agree with
Governor Tarullo's point that Congress and supervisors should exempt all community banks
from certain regulations. Exempting is the best way to guard against regulatory trickle-down.
A second fruitful approach to additional tailoring concerns supervision, not regulation. I worry
that our current supervisory methods establish expectations that are too detailed across too
many areas of bank operations and too wide a swath of banks. Alternatively, supervisors
could concentrate on a smaller number of activities that we believe are correlated with bad
outcomes. To be specific, supervisors could choose to focus on rapid loan growth, high
lending concentrations, specific high-risk types of lending and wholesale funding strategies
and skip some of the more detailed reviews. This shift in focus might generate higher returns
to society, in terms of improved safety and soundness per dollar spent, than detailed work
programs. To be clear: I'm suggesting a tailored approach, and so supervisors could retain
the more comprehensive, proscriptive approach for larger, systemically important banks.
I offer these ideas not as final prescriptions, but in the spirit of open inquiry. My main point is
that we need to further investigate ways to tailor the supervision and regulation of community
banks. For the remainder of my remarks, I will turn my attention to the country's economic
performance.
Brief economic review
However, don't worry - I won't have as much to say about the state of the economy as I did
about community banking. I'm a member of the Federal Open Market Committee - the
FOMC - and, as a monetary policymaker, my discussion will be framed by the goals of
monetary policy. Congress has charged the FOMC with making monetary policy so as to
promote price stability and maximum employment. I'll discuss the state of the macroeconomy
in terms of these goals.
Let me start with price stability. The FOMC has translated the price stability objective into an
inflation rate goal of 2 percent per year. This inflation rate target refers to the personal
consumption expenditures, or PCE, price index. This is a measure of inflation that is based
on the rate of increase in the prices of all goods and services, including those related to food
and energy. That rate currently stands at 1.6 percent, which is below the FOMC's target of
2 percent. In fact, the inflation rate has averaged 1.6 percent since the start of the recession
six and a half years ago, and inflation is expected to remain low for some time. For example,
the minutes from the June FOMC meeting reveal that the Federal Reserve Board staff
outlook is for inflation to remain below 2 percent over the next few years.
In a similar vein, earlier this year, the Congressional Budget Office (CBO) predicted that
inflation will not reach 2 percent until 2018 - more than 10 years after the beginning of the
Great Recession. I agree with this forecast. This means that the FOMC is still a long way
from meeting its targeted goal of price stability.
The second FOMC goal is to promote maximum employment. What, then, is the state of U.S.
labor markets? The latest unemployment rate was 6.2 percent for July. This number is
representative of the significant improvement in labor market conditions that we've seen
since October 2009, when the unemployment rate was 10 percent. And I expect this number
to fall further through the course of this year, to around 5.7 percent. However, this progress
in the decline of the unemployment rate masks continued weakness in labor markets.
There are many ways to see this continued weakness. I'll mention two that I see as
especially significant. First, the fraction of people aged 25 to 54 - our prime-aged potential
workers - who actually have a job is still at a disturbingly low rate. Second, a historically high
percentage of workers would like a full-time job, but can only find part-time work. Bottom line:
I see labor markets as remaining some way from meeting the FOMC's goal of full
employment.
So I've told you that inflation rates will remain low for a number of years and that labor
markets are still weak. It is important, I think, to understand the connection between these
two phenomena. As I have discussed in greater detail in recent speeches, a persistently
below-target inflation rate is a signal that the U.S. economy is not taking advantage of all of
its available resources. If demand were sufficiently high to generate 2 percent inflation, the
underutilized resources would be put to work. And the most important of those resources is
the American people. There are many people in this country who want to work more hours,
and our society is deprived of their production.
As bankers, you know this all too well. You see this underutilization of resources in your own
communities. I began this talk describing the important link between what you do as
community lenders and what we strive to achieve at the FOMC - namely, to put the
economy's resources to work. The FOMC's low-interest rate policy in recent years has
certainly provided some challenges for banks, but the Committee's ultimate goal is one that
we share with you - a stronger, growing economy that benefits all. On that, I'm sure we can
all agree.
Thank you once again for the invitation to join you here today. I look forward to your
questions.