Worry about Lack of New Banks, Not 'Record Profits'

The House Committee on Oversight and Government Reform just had a hearing about the Federal Deposit Insurance Corporation's (FDIC) application process for de novo (new) banks. The purpose of the hearing was to uncover why we have so few new banks of late: Is it the slow economy and low interest rates, the regulations or something else driving away new applicants? Maybe the answer is: all of the above.

As a recent Federal Reserve Bank of Richmond study showed, the number of new banks has declined significantly since 2009. The decline coincided with the end of the crisis and the FDIC's prolonging of the de novo period, during which new banks must adhere to their capital plans, from three to seven years. (Interestingly, an earlier Richmond Fed study observed how the FDIC similarly tried to restrict entry after the much larger number of Depression-era failures.) That the FDIC reversed this rule earlier this year could mean staff there acknowledge the rule's adverse effects.

On the other hand, another study by Federal Reserve Board economists found that non-regulatory economic factors, such as low interest rates and other measures of economic activity that drive down profitability, explained at least 75 percent of the decline in new banks. The authors do not measure the effects of specific regulations, merely the increase or decrease in the number of de novo banks after the passage of a law. Still, the study does find that the Dodd-Frank Act, together with the FDIC's rule change, had the largest (and most negative) effect of any previous law on new bank applications. That means laws and regulations probably have some effect, even if we cannot precisely measure it.

Moreover, as my colleague Patrick McLaughlin shows in a recent co-authored study, the regulatory restrictions embodied in the Code of Federal Regulations may have reduced gross domestic product (GDP) in recent years by as much as $4 trillion. With a relatively smaller economy, it's easy to believe fewer opportunities would exist for bankers.

A related and unresolved issue that came up during the recent congressional hearing was the "record profits" in the banking industry and whether those profits could be consistent with reports of declining profitability. Yes, industry profits in dollars may be at record high levels, but so are total U.S. banking assets and GDP (which might be higher with fewer regulatory restrictions). "Record profits" in dollar terms could just reflect the fact that the economy as a whole (as measured in dollar values), not just the banking industry, is larger than ever before. Just as people may experience a decline in income while GDP rises to record highs, banks may experience declining profitability even with "record profits" for the industry.

Finally, some at the hearing voiced concerns about the decline in the total number of banks. Barriers to entry exist, which could present problems for the longer-term performance of the industry, but the total number of banks is also affected by industry consolidation.

Written before the 1994 Riegle-Neal Act, which paved the way for interstate banking and consolidation at the federal level, a Richmond Fed study conjectured that interstate banking would mean the number of banks would decline. The study suggested, as a simple thought experiment, comparing the number of banks to the size of the population to get a rough estimate of how many banks might exist without the geographic barriers to banking.

According to the study, inferring from California's banking industry and population, the number of banks under interstate banking might be as high as 3,700. On the other hand, inferring from Canada's banking industry and population, the number of banks under interstate banking might be as low 75 banks (with most operating branches nationwide). All this is to say, we're likely still way above the range we might expect to see with competitive interstate banking.

Going forward, proposed laws and regulations that favor banks of a certain size or scope, such as the GOP's new plan to bring back the Glass-Steagall Act, reflect a return to our error-prone past. Neither the Great Depression nor the recent crisis were about the divide between commercial and investment banking. And as Professors Charles Calomiris and Stephen Haber wrote about in their book "Fragile by Design," we've had many banking crises throughout U.S. history, largely because of such policies. Let's let customers decide the number, size and scope of their banks, not lawmakers and regulators, no matter how well-intentioned.