Senate Hears Testimony Regarding Effects of Economic Crisis on Community Banks and Credit Unions in Rural Communities

By W. Bernard Mason

On July 8, 2009 the Senate Financial Institutions Subcommittee held a hearing focused on the role smaller financial institutions play in the nation’s economy, particularly in rural communities. In opening the hearing, Subcommittee Chairman Tim Johnson (D – SD) stated: “Throughout our nation’s economic crisis there has often been too little distinction made between troubled banks and the many banks that have been responsible lenders.” He said that community banks and credit unions, for the most part, did not contribute to the current crisis, yet small lending institutions in rural communities and their customers are feeling the effects of the subprime mortgage crisis. “Jobs are disappearing, ag loans are being called, small businesses can’t get the lines of credit they need to continue operation, and homeowners are struggling to refinance.”

The Subcommittee heard from the following witness panel: Jack Hopkins, President and CEO of CorTrust Bank N.A., Sioux Falls, SD, testifying on behalf of the Independent Community Bankers of America; Frank Michael, President and CEO of Allied Credit Union, Stockton, CA, testifying on behalf of the Credit Union National Association; Arthur Johnson, Chairman and CEO of United Bank of Michigan, Grand Rapids, MI, testifying on behalf of the American Bankers Association; Ed Templeton, President and CEO of SRP Federal Credit Union, North Augusta, SC, testifying on behalf of the National Association of Federal Credit Unions; and, Peter Skillern, Executive Director of the Community Reinvestment Association of North Carolina.

Mr. Hopkins stated that “community banks played no part in causing the financial crisis and have watched as taxpayer dollars have been used to bail out Wall Street investment firms and our nation’s largest banks considered ‘too big to fail’”. “During this same time period, dozens of community banks have been allowed to fail while the largest and most interconnected banks have been spared the same fate due to government intervention”. He cited an ICBA study completed in March indicating that community banks are still lending and 40 percent have seen an increase in origination volumes in the last year, while 11 percent believe the financial crisis has “significantly curtailed” their lending ability. He said the survey indicated that some of the reduction in lending activity was a reaction to the mixed messages coming from the government. While banks are being told by policymakers to lend money, he said they also feel the agencies are dissuading them from lending by putting them through overzealous regulatory exams. He said that, while the largest banks saw a 3.23 percent decrease in lending in 2008, institutions will less than $1 billion in assets experienced a 5.53 percent increase.

Mr. Hopkins said bankers are concerned with the potential for their regulators to second-guess their desire to make additional loans and some bankers are under pressure from their regulators to decrease their loan-to-deposit ratios. He said bankers also stated regulators do not want them to use FHLBank advances for loan funding purposes, suggesting they are not as stable as core deposits. He commented that bankers believe the real issue is the FDIC does not want to have a secondary position behind the FHLB should there be widespread bank failures. Mr. Hopkins stated that FHLBank advances have become an important source of funding for community banks and that it must be allowed to continue.

Mr. Michael testified that credit unions are careful lenders and that their incentives are aligned in a way that ensures little or no harm is done to member-owners. He said toxic mortgages such as subprime loans were made by non-credit union lenders and were focused on maximizing loan originations even though many of these loans were not in the borrowers’ best interests. Further, credit unions hold most of their loans in portfolio. He observed that strong asset quality and high capital kept most credit unions “in the game” while the other lenders pulled back. He pointed out that, for the year ending March 2009, real estate loans at credit unions grew by nearly 9 percent, while banking industry real estate loans declined by approximately 2 percent. He also said business loans at credit unions grew by nearly 16 percent during this period, whereas commercial loans at banking institutions declined by 3 percent. In his view, the credit crisis has been exacerbated by the fact that credit unions are subject to a statutory cap on the amount of business lending they can do. He said Federal Reserve and SBA surveys have shown that it is now more difficult for small businesses to obtain loans and this is a market that credit unions are well suited to serve. He indicated a growing list of small business and public policy groups agree that now is the time to eliminate the cap and he hopes Congress will act on this issue.

Mr. Johnson stated that, in spite of the recession, community banks located in rural communities have expanded lending. He said loans from banks headquartered outside metropolitan statistical areas increased by 7 percent in 2008, and lending by farm banks had increased by 9.2 percent. He warned that these trends are not likely to be sustained and it is unlikely that loan volumes will increase in 2009. Although credit quality has suffered, he pointed out that community banks entered the recession with strong capital levels; however, he said it was extremely difficult to raise new capital in the current climate and without access to capital, the flow of credit in rural communities will be difficult to maintain. He pointed out that the Capital Purchase Program and other initiatives have been focused on the largest banks. Additionally, the changing nature of the CPP and its restrictive selection process prevented banks that could have benefited from the CPP from doing so. He suggested that now is a critical time to focus on strategies to assist community banks. He proposed the following: broadening capital programs to enable participation by a greater cross-section of banks; revising the risk-based capital rules to better reflect the risks presented; and, avoiding inappropriately conservative appraisal/asset valuations. Mr. Johnson said the ABA believes creation of a systemic risk regulator, providing a mechanism for resolving systemically important institutions, and filling gaps in the regulation of the shadow banking industry should be the focus of Congressional action.

Mr. Templeton reiterated most of the points made by Mr. Michael, including the appeal to remove the business lending cap. He also suggested a legislative change that would clarify the ambiguity regarding the ability of federal credit unions to add “underserved areas” to their fields of membership. He said NAFCU supports creation of a Consumer Financial Protection Agency, but believes that its mission should be limited to currently non-regulated institutions operating in the financial services marketplace.

Mr. Skillern reported that while a number of small banks across the nation have failed, far more have been lost through consolidation over time. He said that nationally, the number of banks under $100 million in assets dropped by 5,410 from 1992 to 2008. By contrast, he stated that in 1995, the top five banks had 11 percent deposit share; today, they hold nearly 40 percent. He noted that small banks are at a competitive disadvantage in terms of pricing, products and geographical area. He said that, while the effects of the recession are felt by every community, rural communities will shake off its effects much more slowly.

Subcommittee Chairman Johnson sought the panel’s views on the FDIC’s move to base its special assessment on institution assets, not deposits. Mr. Hopkins said he supported the move, since assets represent the risk, not deposits. He said it is a positive move for community banks and he suggested it be adopted for regular assessments going forward. Mr. Johnson said he had some concerns about a rush to make this change without further analysis of the impact. He further felt that no changes should be adopted until a decision is made on the program and process for a systemic risk resolution mechanism.

Chairman Johnson then asked the panel whether loan modification programs would be useful for rural areas. Mr. Michael said subprime, zero-down mortgages clearly contributed to the current problem and, while credit unions did not originate these loans, his institution is trying to assist customers who have these loans with other lenders. He said he had found those lenders to be slow on the modification process and were not geared to process these requests. He said delays are substantial and results generally are not positive. Mr. Johnson said his bank was experiencing higher levels of delinquencies and foreclosures. He said these problems had all been driven by unemployment issues, not product-type or initial underwriting issues, and his bank was working diligently to keep these families in their homes. He said he is also seeing customers who opted to take out mortgages from other broker/originators come in to request a solution to their problem, and he said he has been able to refinance approximately 20 percent of these cases. Mr. Templeton said he had not seen many questionable loans made in his market area, mainly because brokers were not interested in loans on homes in rural areas since they could not be packaged and sold – there was no appreciation in value.

Ranking Member Mike Crapo (R - ID) said he was concerned about the Administration’s plan to bifurcate prudential supervision and consumer protection functions and requested the panel’s views on this topic. Mr. Johnson said he does not believe the case has been made to do this and he believes it would be very difficult to administer, since the two interests may conflict. He said 94 percent of the high-risk lending that got us into this problem was originated by unregulated entities, and he felt the focus should be on that problem, not over-regulating the other 6 percent. Messrs. Hopkins, Michael and Templeton stated their agreement with Mr. Johnson. Mr. Skillern said he would disagree that the federal regulators had done their jobs well. Countrywide and Washington Mutual pursued their subprime and predatory lending practices under the watchful eye of the OTS and Wachovia crashed itself on exotic mortgage lending while regulated by the OCC. He said he is currently in a fight with the OCC over formal enforcement of its rules regarding a refund anticipation program at another institution. He concludes that proper consumer protection is just not happening. He stated that federal regulators have lost credibility on their willingness and ability to enforce the existing consumer laws. He believes a separate agency is needed to bring standardization to the application of consumer rules and reduce the apparent conflict of interest federal regulators have in enforcing such laws.

Senator Michael Bennet (D – CO) asked the panel’s views on how well TARP is working for small, community banks. Mr. Hopkins said in his view TARP has helped pick winners and losers. He said the big banks have been chosen as winners, because even though they were technically broke, they were bailed out. He noted that smaller community banks that are not 1- or 2-CAMELS rated cannot qualify for these funds. He observed that this creates an unfair advantage for larger banks. Mr. Johnson said that to some degree, everyone is guessing as to what the criteria are and how the process works, because details have not been made public either by Treasury or the regulatory agencies making the recommendations. He argues Treasury and the agencies should work hard to determine which banks are viable and make sure that they have access to capital, so that banks are not closed unnecessarily.

Senator Bob Corker (R – TN) implored Mr. Johnson to have the ABA weigh in on the Administration’s proposal on “too big to fail”. Senator Corker said it is evident that the Administration wants to continue business as it has been over the past year and basically “codify” TARP so they can decide on an ad hoc basis which firms will succeed and which will fail. He also expressed his concern that the Banking Committee had not held hearings on Fannie Mae and Freddie Mac in over one year. Senator Corker then asked the panel if they believed it would be better if Fannie and Freddie did not exist. Both Mr. Hopkins and Mr. Johnson firmly stated that it was essential that community bankers have a secondary market source where they could sell their originated loans. They explained to Senator Corker how lending capacity would quickly be reached if all loans were retained in portfolio. In response to a follow-up question from Senator Corker, Messrs. Hopkins and Johnson stated that their correspondent banking sources had significantly declined in the past year, making Fannie and Freddie “the only game in town”. Senator Corker retorted that the regional banks – “those folks who we are here constantly talking to about making loans and they are constantly telling us they are making more loans than they made in the past, those folks, as far as their correspondent relationship, from your perspective, that has gone away”? “It has gone away in that respect”, replied Mr. Hopkins.

Senator Corker concluded his questioning by stating his belief that regulators are helping create a self-fulfilling prophecy by virtue of the way they are dealing with institutions. He feels “regulators are clamping down and making this recession more severe than it otherwise would have been”.

Senator Jon Tester (D – MT) began his questioning by stating his agreement with Senator Corker’s assessment of regulator actions. Senator Tester then inquired as to the panel’s view on the Administration’s proposal to combine banking agencies. Mr. Hopkins said that, even if the OTS were merged into OCC, there should be a separate office that focuses on mortgage lenders. Senator Tester concluded his questioning by stating that “community banks need to be regulated, but you are not the ones who caused the problem. The Wall Street people were the ones and the ‘too big to fail’ is something I have a great disdain for, and we need to re-think some of these operating systems we have in this country.”

Subcommittee Chairman Johnson said that the Banking Committee will continue its review of the current structure of the financial system and develop legislation to create the kind of transparency, accountability, and consumer protection that is now lacking. As this process moves forward, he said it will be important to consider the unique needs of smaller institutions and to preserve their viability.