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George: Regulatory Environment ‘Misaligned’

April 6 – In remarks at the New York Fed’s Community Banking Conference, Kansas City Fed President Esther George said that the evidence indicates that community banks are extremely important to our economy.

“The regulatory net has ensnared thousands of community banks,” said KC Fed President Esther George at the New York Federal Reserve Bank’s Community Banking conference.

“Market forces of technology and innovation are everywhere and community banks will need to be responsive to customer demand for new services and methods of banking,” she said. “But these are not the forces that particularly concern me. The risk I see stems from a misaligned regulatory environment that poses a threat in my view to the diversity of the U.S. banking system and healthy competition that has long served the country well.”

The nation stands at a crossroads of policy choices, according to George, and as policymakers consider regulatory reform, the special role of banks in our economy and particularly the role of community banks, must factor into their decisions.

The regulatory response that followed the financial crisis was well intended and even justified in its aims to end too big to fail and protect consumers, she noted.  “However, while the aim was specific to the largest banks, the regulatory net has ensnared thousands of community banks,” George said. “Regulators have applied supervisory approaches and protections that often fail to take into account the incentives and risk profile associated with relationship lending models of community banks.”

As an example, the Kansas City Fed president cited international capital standards, which formed the basis to reduce leverage in the biggest banks, layer on unnecessary reporting requirements and complexity for banks that already held high levels of capital.

“Appraisal standards aimed to ensure independent valuations support new loans create challenges for thousands of smaller banks that are portfolio lenders,” George said. “These small institutions, often located in more rural markets, struggle to find knowledgeable appraisers with sufficient comparable property sales to comply with the rules, and in some cases, conclude that qualified borrowers’ credit needs can’t be met.”

Rules aimed at protecting consumers and other customers from unfair and deceptive practices are important, George acknowledged. “However, long-term relationship lending also aligns the incentives that protect community bank customers,” she said. “Unfortunately, the compliance burden for community banks introduces costly processes along with fear and confusion as they struggle to apply narrow legal interpretations and opaque statistical models to the fair credit needs of their borrowers.”

Ultimately, communities suffer when access to credit is unnecessarily limited, and so does the larger economy, George noted. “Rules that aim to address the business models and incentives of the largest banks may unintentionally put the diversity of the banking system at risk, and the lack of new bank charters over the past decade suggests the barriers to entry may be high,” she said.

The regulatory remedy for today’s banking system will not be easily prescribed, in George’s view. But it will need to recognize that the institutions collectively referred to as “commercial banks” have drifted apart over the past 35 years, she believes.

“At one end of the spectrum are banks that engage in global financing with systemic implications for failure and impact to the broader economy,” George said. “At the other end are banks that engage in traditional lending and deposit-taking, whose impact on small business and small communities translates to real economic outcomes.

“Today, the federal safety net supports both models and it is sagging,” she added, “stretched by ever-larger and more complex firms with significant nonbanking activities. Banking regulation must do its best to offset the very real exposures for taxpayers and the risk to economic and financial stability. Nurturing incentives that reward success and punish failure are key.

“Aligning regulation that effectively addresses risk at both ends of this spectrum will require that regulators either close the gap between their differences or embrace the two models and attempt to apply very different supervisory frameworks and approaches,” George said.

George concluded her remarks to the New York conference with this thought:  “As a highly concentrated banking system takes hold in the U.S.,” she concluded, “the issue of today’s banking landscape poses a slightly different but important question about the ability of regulation to differentiate its aim. It will matter to thousands of communities served by you in the years ahead, and by extension to the U.S. economy.”


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