How the Decline in Community Banks Hurts Small Business Dodd-Frank has weakened community banks, a lifeline for many small businesses.

A recent report from the Federal Reserve Bank of Richmond reveals that the number of community banks dropped by a whopping 41 percent between 2007 and 2013. That's bad news for small business owners, who rely heavily on financing from small, local banks.

Even more troubling is the potential culprit. Analysis by the Fed suggests that the Dodd-Frank Act is at least partially responsible.

A Harvard University study shows that the rate of decline in the community bank share of commercial banking assets has doubled since the passage of the law in 2010. Moreover, almost all of the decline in the number of community banks in recent years has resulted from a cessation in bank formation during the current economic recovery, the Richmond Fed reports.

Small businesses often rely on community banks for capital. Unlike big public companies that can issue new stock or sell bonds and commercial paper when they need money, small businesses are much more reliant on banks to provide them with the financing they need. Among banks, community ones tend to be their most common financiers. Many big banks avoid extending credit to small companies because small business loans are time intensive, hard to automate, tough to securitize, and expensive to underwrite and service.

Moreover, community banks have an advantage at relationship-lending. Embedded in local communities, they are better able to evaluate soft factors in lending decisions, which allows them to make loans when quantitative analysis based on credit scores and financial statements alone would not suggest it. As a result, community banks provide over half of all small business loans, despite accounting for less than a quarter of all business lending.

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The Dodd-Frank Act has made community banking more difficult. The law increased total U.S. financial regulatory restrictions by nearly one-third and has required community banks to purchase new software, hire additional compliance personnel, and to spend more time responding to government oversight than before. More than four of every five small banks believes that compliance costs have increased since the passage of the Act, a recent survey shows.

Increased regulatory compliance is particularly problematic for community banks. Those institutions did little to create the problems that the Dodd-Frank Act was designed to combat. Moreover, regulatory compliance has a high fixed cost, making it disproportionately expensive for smaller institutions. Some bankers report that regulatory compliance accounts for more than twice as high a share of operating expenses at community banks than at their larger counterparts.

The Richmond Fed suggests that the Dodd-Frank regulatory increase is at least partially responsible for the recent decline in community bank formation. The additional rules have reduced the profitability of community banking, with some estimates showing that as many as one-third of community banks are unprofitable under the new regulations. With community-banking profitability in decline, it's not surprising that fewer people are willing to start those banks and that the people running existing ones are exiting the business.

Policymakers should exempt community banks from many of the new regulations imposed by Dodd-Frank. Those regulations were designed to combat problems not present in the community banking model. Perhaps more importantly, failing to protect community banks from collateral damage risks hindering small business access to credit, which depends heavily on effective functioning of the community banking model.

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