Regional Banks: Sitting in the Sweet Spot

Banks play an unquestionably critical role in all aspects of our economy by facilitating payments and supplying credit needed for businesses to grow or for consumers to purchase homes and other consumer goods. Regional banks, those with assets between $50 billion and $500 billion, have a unique place in the financial spectrum that ranges from small community banks to the largest global systemically important financial institutions. The importance of regional banks will be discussed in detail and from many perspectives elsewhere in this issue, but it is important to first step back and consider the role all banks play in the success of our economy.

While bankers understand what banks do and how they do it, many people do not. At the very core, banks allocate capital to the most economically productive purposes. Banks take in excess funds (deposits) from individuals and businesses that have them and make loans to creditworthy individuals who need money for their business or personal use. History shows we get it right about 99.5% of the time. In addition to this core business, we serve our clients by providing financial advice, investments, and insurance, among other services.

Banks are the cog in the wheel that allows money to multiply through the extension of credit and facilitates the goals of monetary policymakers. In doing so, banks’ activities support the growth of the economy and ultimately result in the creation of jobs. Unfortunately, as a result of the Great Recession, many observers and public officials blamed banks for failing to responsibly perform this function. What many do not understand is that by the time the crisis began, banks were no longer the predominant players in what had traditionally been known as the banking business. Instead, a new shadow banking system, comprised of an amalgamation of hedge funds, private equity firms, REITs, investment banks, mortgage brokers, and other nonbank lenders, had emerged. As this shadow banking system facilitated the creation of securitized loans and money market funds, huge flows of loans and deposits migrated to it.

While the banking system was heavily regulated, the shadow banking system was not. This resulted in a misallocation of capital as the players in the shadow banking system did not properly assess the risk of the activities they were participating in. Investor demand for these new securities seemed insatiable, and a huge housing asset bubble was created. The bubble burst, and the public authorities stepped in to support the system. The self-correcting nature of the market was averted, but while such action was necessary, it does become problematic when we are unwilling to let institutions and individuals suffer the consequences of poor decisions. As such, Washington felt obligated to create solutions to ensure such an event never occurs again and thus enacted the Dodd-Frank Act.

I am not suggesting banks were not culpable in the crisis. I am suggesting, however, that because legislators incorrectly diagnosed some of the causes of the crisis, some of the solutions may have unintended consequences. The banking system is being remade as a result of the 2,000-plus page Dodd-Frank Act and the nearly 400 new rules required to implement the law. At the same time, little has been done to deal with the shadow banking system. Ironically, many of the new capital and liquidity rules are squeezing assets and liabilities out of banks and into the less regulated shadows. In addition, the costs associated with complying with these rules have, to some degree, prevented banks from helping support the economic recovery by extending credit for needed investments. The banking industry needs to be properly regulated, but we must not neglect the risks in the shadow banking system. If we do, banks will be at a competitive disadvantage, and we will turn a blind eye to emerging risks in less regulated sectors of the financial system.

Regional banks are an important part of our new economic world. The cost of the regulatory burden and associated resource requirements for technology and compliance, in addition to rapidly changing consumer demands, make scale an economic necessity to generate a reasonable return for our shareholders. Over half of banks today are not generating returns that cover their cost of capital. The long-term implication of this is alarming. During the crisis, banks raised over $100 billion in new capital (excluding capital issued to facilitate acquisitions). Without the ability to generate capital in the future, whether due to subpar returns relative to other industries, poor share price performance, or barriers to providing appropriate dividend payouts, our industry will find itself in a precarious position.

Regulations should be calibrated to account for the minimal or nonexistent risk small community banks pose to the system in order to maximize the probability of their achieving returns above their cost of capital. On the other end of the continuum, some believe that the very large banks, those with assets above $1 trillion dollars, are too big and complex to manage and advocate that these banks should be broken up. My view is that, to the extent that a bank creates more risk for the system, it should be required to hold higher levels of capital and liquidity. Fortunately, this seems to also be the view of the regulatory community. In any case, the regional banks seem to be in a “sweet spot” – large enough to have scale and not so large as to create fear of unacceptable systemic risks.

Regional banks, much like community banks, are trusted Main Street institutions. They employ 400,000 Americans, serve local communities with 22,500 branches, extend financial services to 60 million households, invest heavily in their communities through contributions to non-profits, and lend to individual small businesses and corporate clients. They are not complex institutions and do not individually pose systemic financial risk.

While being in the “sweet spot” should have some advantages for regional banks, the success of an institution will not be dictated solely by its size. Instead, it will be a function of how well an institution manages risks and how well it produces a return for its shareholders. An economy where the banking system is designed to avoid risk at all costs will experience subdued growth at best. A free market economy must be allowed to take an appropriate amount of risk, earn the reward of good risk-taking decisions and suffer the consequences for bad ones. In addition to credit risk, we must also focus on the escalating cybersecurity risk that threatens global commerce. Effectively managing this growing risk will require the cooperation of banks, financial institutions, and merchants and coordination with the government.

Most important, banks must be allowed to perform their economically essential role. A system that constrains banks and leaves the shadow banking system untouched will only transfer the risks, not limit them. Systemically important institutions or entities must be properly identified and appropriately regulated, and they must be resolvable. We need a healthy banking system and a safe shadow banking system both playing by the same rules in order for our economy to continue to grow and our country to realize its full potential. •