Too Small to Survive?
Steep challenges lie ahead for small- and medium-size banks.
Small banks were not supposed to cause this much trouble. In 2008, it was the big banks that went down and nearly took the economy with them. The problem appeared to be too much market concentration, which was said to be the chief problem with the American economy. Now, following the implosion of Silicon Valley Bank and then the failures of First Republic and Signature, no one knows what’s next. It turns out that the world is more complicated.
Like the rest of the economy, large banks are dominating their industry. That’s because often, they are the only ones that can compete. The United States had 9,904 commercial banks in 2000; by 2022, it had only 4,706. Just 13 banks have more than $250 billion in assets, yet their holdings represent 55 percent of all the assets in the banking system. In 2000, only three banks were this large, accounting for just 13 percent of banking assets.
But small- and medium-size banks are a critical part of the banking ecosystem. Despite their shrinking prominence, smaller banks make up a disproportionate share of retail and commercial lending. According to data from Goldman Sachs, banks with fewer than $250 billion in assets account for half of all commercial and industrial lending, 60 percent of residential lending, 80 percent of commercial real-estate lending, and 45 percent of consumer loans.
Without small banks, what will the future of credit be for more modest borrowers? Odds are that more small- and medium-size banks will disappear. It’s not clear whether deposits beyond $250,000—the standard limit for Federal Deposit Insurance Corporation protection—are guaranteed. Treasury Secretary Janet Yellen recently suggested that deposits above $250,000 are insured only at systematically important, or big, banks. The confusion over what is insured may explain why depositors are taking their money to bigger banks. During the week of March 15, deposits at small banks shrank by $66 billion, while deposits at large banks grew by $120 billion.
But even if all deposits were guaranteed, small- and medium-size banks would face challenges. Banks make their money by taking in deposits, paying interest on them, and either lending that money out or investing it in longer-term and riskier assets that generate a higher return. As interest rates increase, banks should theoretically benefit from the higher returns on their assets because those rates reset when the market rates increase. But some banks hold assets with yields that don’t increase, and in fact fall, when market rates rise. And in a rising interest-rate environment, banks face pressure to pay higher interest on deposits; otherwise, depositors will take their money to better-paid money-market funds. The consequence is lower profit margins—a big problem for smaller banks.
Longer-term, the outlook is worse. Even if the current crisis passes without more bank failures, smaller banks will find themselves subject to much stricter regulation. Regulation has become very costly for all banks, but it is especially burdensome for small banks with fewer resources to devote to compliance. That’s one reason for the now-reviled regulatory change in 2018 that relieved smaller banks from the burdens of Dodd–Frank. Small- and medium-size banks likely will face more regulation, which will make them less profitable and spell more consolidation in the future.
In this climate, that might seem to make the world safer. After all, larger banks currently appear more stable and have more resources to comply with regulators. But just a few years ago, market concentration seemed to be the biggest risk. Fewer small banks would also mean less bank lending and tighter credit; retail borrowers going elsewhere for credit while facing higher borrowing costs; and less transparency. If changing market forces in a high-tech world favor larger banks, our economy may be more efficient. But if regulation and Fed policy ultimately drives small- and medium-size banks out of business, we will lose something valuable and important.
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