Small Banks, Big Benefits (Episode 16)

I think we wanted to talk about what’s happening with local banks. Justin, I wonder if you could just start by talking about what a local bank is. You had noted when we talked previously that you have a lot of experiences and have a real good sense of what’s happening but some of the stuff we’re talking about might be more specific to more rural or non-metro community banks.

For small community banks that are doing small loans like we are; under $100,000 for the most part, even under $50,000 on mortgages, the time invested in those relationships it’s not cost effective for Bank of America to build a business model on that and provide value to its shareholders, whereas for us it’s a necessity. We have to do those loans. It’s vital for our community and our market share. We’re going to spend our time doing those things and spend our relationships with very small loans versus you could talk to a Bank of America customer who probably has a line of credit unsecured that’s $75,000 to $100,000. I would say I put on more mortgages for $75,000 to $100,000 in the last 3 months than I would ever put on unsecured. My board would be a little concerned if I was putting on unsecured loans for $75,000 to $100,000 with the customer base that we have. It’s at that level you’re building those businesses and keeping them in your communities, and that’s where we have to be.

On the other side there’s the rate difference. When you try to have a discussion and negotiation, Bank of America stated rates in the Wall Street Journal are going to be a lot lower because they’re dealing with large loan customers, large companies. We’re dealing with small customers, smaller scale relationships, and we’ll have a little bit higher rate. On a nominal level it’s obviously much less in interest they’re paying. It becomes that discussion to the general public, why are small community banks charging a higher rate. Well, the scale is a very misleading factor and it becomes too simple, I guess, to report the rates for each institution and not consider the fact that there’s a lot of costs that goes into these relationships.

Well, going back to the financial meltdown and the mortgage crisis, a lot of people assumed that every mortgage was the same. Well, it’s not the same and that’s why Dodd-Frank came [in vogue 00:08:27] and that’s why a lot of the regulation came was to weed out what different mortgages really cost. When you’re in the business of making a lot of loans and keeping rates low, you’re going to have to make money somewhere, and it’s going to be on the fee side and that’s where the large banks lived. It was putting fees into their contracts, into their mortgages, into their lending relationships, deposit relationships to pay for the overhead to do these types of loans versus a bank that has a long lasting relationship with a customer that has a deposit account that has been there since they were a child. The products become a relationship based where you’re going to price into that relationship more on the rate side because it’s an ongoing relationship versus the large banks, which are trying to securitize these mortgages and sell them off the investors. They’re not holding them locally on their balance sheets and to do that they’ve got to get to the lowest cost point but they’ve got to make money to keep in the doors. The more they can do, the more money they can make, and they’re going to do that on the fee side.

I actually was curious on this topic. The way I look at it as a banker is on my gross income for the year; how much is coming, what percentage is coming from non-interest income, which is fees, and what percentage is coming from interest income. I tend to look at things in our industry as small maybe being $1 billion versus the legislation says a $10 billion bank is a small bank. I would say under $1 billion. Banks under $1 billion, as a percentage of total income have 16.5%. Banks over $1 billion are at 21%, 5-6% more of their income is coming from fees. We’re charging less fees but a marginally higher interest rate. We feel that is a better way to price a relationship. We’re saving them money on the cost side.

When you talk about your bank, what you’re saying is we want to make money on the interest, meaning that we want to have customers who are able to pay back their loans. We’re going to have a long term relationship with them because over time as they pay back those loans we’re going to make money on the interest. It’s really striking because that essentially means that your bank can’t be profitable and do well unless your customers are doing well. Whereas a big bank, and we saw this spectacularly in the financial crisis, they can collect all those fees and blow up the economy and their customers can lose their homes and have every bad thing happen to them financially and the banks are still fine because they’re not tied to those customers anymore. Whereas you have this very connected relationship to your customers’ well-being. I imagine, especially being in a small community, if the town is doing well you’re doing well, and if the town is doing badly you’re doing badly.

I think that comes from having a stake in the game. I think that’s why the interest margin and that profit focus has always been a much more trustworthy relationship but large marketing and misleading fees and what you can control of what the customer sees can make that … Big banks say we just charge lower rates. It’s compelling but it’s on us as a small financial institution, a small community bank to change that discussion by educating our customer base and marketing based on education and put a real focus on financial literacy. I think that is where our industry is really failing. That’s an opportunity for us to really get into schools, get into households, and educate because it’s not being done properly.

A good example is the Civil Service Member Relief Act, where we have to pull a report on any consumer customer to verify they’re not in the active military. I could have somebody I went to high school, somebody I know very well, maybe my next door neighbor come in and if I don’t pull a report verifying that I looked that he’s not an active military member, I will be written up and could face a violation. That is ridiculous, in my opinion. Should it be done in certain communities, in certain localities, and with certain scale of banks and did they abuse it? I bet they did, but for us it’s tiring and when you add more and more regulation like that that includes us small independent banks that we’re very much not the problem, board rooms get exhausted, strategies get co-opted, and they feel the pressure to sell because they just don’t feel the liability and the profits that are being siphoned off for regulation is worth it.

A good example of how much regulatory cost is I’ve seen surveys out there that say banks are facing 5 to 8% more in regulatory costs. Our bank alone, I did this math off our budget last year, 20% more of our net income I think is gone due to increased regulation. That’s a large figure to explain to a board. Then we have to make up for that in other areas and trying to get into niche lending, which I think you’re confining yourself to more of a type of loan that makes you more susceptible to economic turns and even more so you get into the fact that a lot of our products are being co-opted out of us so we’re less diversified in our portfolios than we’ve ever been because the regulation is forcing those products to bigger banks that have more economies of scale.

The ones that are operating like large banks are the ones that are giving credit unions a bad name and are the ones that are really causing the local community banks, which in my opinion my community bank operates a lot like the way credit union is intended. Everybody who’s a customer of my bank is somebody from my local community. They have a common affiliation. We’re in a lot of ways like the original credit unions were intended, but as we get nameless and faceless and we get more profit motivated and more scheme motivated the legislation has allowed the large credit unions into areas like commercial lending where they don’t have, number one, the expertise and, number two, the jurisdiction. They’re not intended to be there. They’re only there because it drives more profit for them to in some ways give back to their members but now their members are probably more vague than you and I. We have more in common than probably a lot of the credit union members in the large credit unions.

That is the issue that drives us. We started things with a fee-based motivation or an interest or long term relationship based, those statistics that I cited on percentage of gross income coming from non-interest income, credit unions beat banks far and ahead. The large credit unions have 30% of their gross income coming from fees. My small bank that I work for is 3.5% of our gross income comes from fees. That’s a commodity-based relationship.

We also limited the ability of banks to mingle different kinds of businesses, so if you were a commercial bank with FDIC insurance, that is the government taxpayers were protecting your deposits, you couldn’t engage in like Wall Street gambling. You couldn’t do all of the securities trading that you see big banks doing now. We had this strict separation, so if you want to be an investment bank and do Wall Street stuff, great but you’re not going to have an insured deposits. If you want to be a commercial bank, then you can’t be messing in that kind of stuff.

Those two policies really kept banks much more regional or local in their focus, much safer over the long term, but the other great thing about that structural approach is that we then didn’t have to write all these nitty gritty rules governing every little bit behavior because we just kept created the right kind of structure to align banks with their communities. Obviously we had some consumer protections. We need those kinds of things, but we didn’t have to have just this crazy mass of rules because we weren’t trying to govern these really institutions in the case of Bank of America, Wells Fargo that have become so big and complicated that they’re really ungovernable. It seems to me when we talk about regulation that part of the problem is it’s not more or less regulation, it’s smart regulation is the issue.

The other hopeful message is I just feel community banks, in general, have a nice opportunity to drive financial literacy and to do very interesting things to build trust in their communities, they just have to focus on that aspect of it and have the wherewithal that they’ve had for over a hundred years to be there and be the consistent presence. These other banks and these other institutions will be in and out. If we stay invested truly in our customers we’ll be there and be profitable.

Justin, I’ll just put you on the spot really quick. Is there anything you think people should read; an article, a book that would give them a better sense of this industry?

I wish I had a lot of great articles and a lot of good things for people to read. I don’t just because our industry is pretty much obsessed with being delved into our individual communities.

As a reminder, check out fnbosakis.com. If you scroll down, you’ll see the Financially Literate tool that Justin mentioned in the interview. Also, don’t forget to go ILSR.org for the tool Stacy mentioned to help you make the switch to a community bank.

We encourage you to subscribe to this podcast and all of our other podcasts on iTunes, Stitcher, or wherever else you get your podcasts. You can sign up for our monthly newsletter at ILSR.org. Thanks to Dysfunction Al for the music license through Creative Commons. The song is Funk Interlude. I’m Lisa Gonzalez from the Institute for Local Self-Reliance. Thanks again for listening to episode 16 of the Building Local Power podcast.