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Too Small To Fail

Where does banking in America need to go? Back to the future.

Article posted on USAToday.com
By Phillip Longman and Ellen Seidman

Last fall, Countrywide Financial, then the nation’s largest mortgage lender, had a curious new idea —or, more precisely, an old one. No longer would it slush foreign capital through Wall Street to make subprime loans. Instead, the lender would depend entirely on deposits from savers who would finance one another’s mortgages —kind of like that humble thrift institution run by George Bailey in the movie It’s a Wonderful Life.

(Web Bryant, USA TODAY)

Sadly, Countrywide waited too long to get back to basics and became the first major bank of 2008 to require a desperate rescue. But it is not too late for other financial institutions. Indeed, with the world’s system of anonymous high finance in crisis, there is a strong case for fostering many more small-scale, traditional depository institutions like George Bailey’s.

So far this year, the failure rate among big banks is eight times greater than among small banks. The latest data from the Federal Deposit Insurance Corp. show banks with less than $1 billion in assets outperforming larger banks on most of the key measures.

According to the theory that brought us bank deregulation, this can’t be happening. Large financial institutions are supposed to be more efficient because of their economies of scale and, more important, because of their ability to match lenders and borrowers wherever they might be. Banks with global reach can take capital from wherever it is in large supply (say China or the United Arab Emirates) and direct it to places where it is in short supply, no matter how distant (say Stockton, Calif., or east Cleveland).

Redefining loyalty

On the strength of the big-is-better theory, global-scale “transactional banking” has been allowed to displace small-scale “relationship banking.” Internet mortgage originators such as LendingTree run TV commercials mocking the idea that a consumer should be loyal to any one bank. “When banks compete, you win,” goes the LendingTree slogan. The message: Forming a relationship with a small-scale banker —as George Bailey did —is for chumps, transactional banking for the savvy.

But is bigger really better? Today we can see that the new system of global transactional finance invested the world’s savings in a spectacularly irrational manner. The savings that poured into underwriting zero-down mortgages on McMansions and tract houses far from jobs could have been more profitably invested in just about anything else, such as for America’s conversion to sustainable energy sources or retooling our manufacturing sector.

In contrast, small-scale financial institutions generally avoided subprime lending, concentrated on traditional mortgages and small business loans, and today are in comparatively good shape. Though vulnerable to a downturn in the economy, they are generally resistant to the financial contagion infecting larger institutions.

What’s the moral?

It is now clear that a lack of a relationship of mutual interest between lender and borrower was at the heart of the breakdown in global finance. All the players in the system, from mortgage brokers to investment banks peddling “asset-backed” securities, had little interest in whether consumers could actually afford their debt.

Unlike a traditional community bank, most large banks didn’t hold any of the mortgages they wrote and didn’t depend on deposits from the same people to whom they made loans. Instead, they made their money mostly on fees.
In small-scale banking, by contrast, there is a mutual interest between borrower and lender. Both are members of the same community and as such are able to judge each other’s prospects better than borrowers and lenders on opposite sides of the globe.

Put another way, small-scale banks are rich with what Federal Reserve Chairman Ben Bernanke calls “informational capital,” which, he explains, they develop through “gathering relevant information, as well as by maintaining ongoing relationships with customers.”

What next for small banks?

George Bailey put it better in his clinching argument to panicked depositors. The residents of Bedford Falls could rest assured that their money was safe because they knew one another: “Well, your money’s in Joe’s house. That’s right next to yours. And in the Kennedy house, and Mrs. Macklin’s house, and a hundred others. Why, you’re lending them the money to build, and then, they’re going to pay it back to you as best they can.”

The biggest problem facing small banks today is attracting equity capital from stockholders. Most small banks are privately held, and even for those that are not, interesting the public in bank stocks is not easy. It’s a problem that could get worse for small banks if, after all the bailouts, just a few giant financial institutions control most banking.

We are pleased to see the Treasury Department announce it will use some of its $700 billion in rescue money to invest in small-scale banks. For the longer term, however, we need a dedicated tax on the securitized loan transactions of the rest of the financial services industry. The revenue raised could flow to a federal Community Bank Trust fund to ensure that small-scale banks expand in number and market share.

This would support the capital and other needs that enable community banks and credit unions to serve their communities —including minorities, immigrants and those of modest means. In the movie, George Bailey got to see what the world would look like if he weren’t in it. Today, a world that largely passed him by looks ugly indeed.
Phillip Longman, a senior fellow at the New America Foundation, is co-author of the forthcoming book The Next Progressive Era. Ellen Seidman is director of financial services policy at New America and served as director of the Office of Thrift Supervision from 1997 to 2001.