In the fall of 2007, Countrywide Financial, then the
nation's largest mortgage lender, had a curious new idea -- or, more precisely,
an old one. It would no longer import foreign capital through Wall Street to
make subprime loans. Instead, it would depend entirely on deposits from savers,
who would finance each other's mortgages -- kind of like that humble thrift
institution run by George Bailey in the movie It's a Wonderful Life."
Sadly, Countrywide waited too long to go back to
basics and became the first major bank of 2008 to require an urgent rescue. But
it is not too late for other financial institutions. Indeed, with the world's
system of anonymous high finance in crisis, and pressures -- including from the
government -- building for even greater consolidation, there is a strong case
for fostering many more small-scale, traditional depository institutions like
So far this year, the failure rate among big banks
is seven times greater than among small banks. The latest available FDIC data
show that banks with less than $1 billion in assets are outperforming their
larger peers with respect to the critical metrics of return on assets, net
interest margin, and the all-important net charge-offs to loans and leases.
While banks with between $100 million and $1 billion in assets charged off 0.37
percent of loans and leases, those with over $1 billion in assets charged off
This idea is also explored by Phil Longman
and New America Fellow T.A. Frank in an article
that appears in the November/December 2008 Washington Monthly.
Once regarded as at best niche, and at worst
vestigial, players in a new world of global consumer finance, small-scale
community banks, thrifts, and credit unions have the potential, if favored with
appropriate public policy, to ameliorate many of the country's deepest
problems. These include a dangerously high level of concentration within the
financial services industry -- a problem made especially acute as the Treasury
rescue package allows big banks to get bigger. The promotion of small-scale
banking can also help to improve the nonexistent savings rate, high consumer
debt levels, and dwindling supplies of social capital in many areas. Finally,
increasing the number and health of small-scale financial institutions can also
help to overcome the lack of mutual interest between borrowers and lenders that
is at the heart of the current global financial crisis.
Community banks and credit unions don't need a
bailout, but they could use some help to deal with two major issues: the high
fixed costs of some business essentials (such as information technology and
meeting regulatory compliance costs) and access to capital, especially patient
capital that will support them as they serve communities that now, more than
ever, need both a place to save and access to responsible credit. We propose a
Community Banking Trust Fund to respond to these needs.
The proposed fund would make equity investments in
small-scale depository institutions that need patient capital to serve their
communities effectively. For credit unions and mutually owned banks that do not
issue stock, the fund would provide net worth certificates, which would count
as equity, but pay a set interest rate.
In addition, the fund would make technical assistance grants to cover critical
investments in areas such as information technology and disaster recovery.
The fund would encourage these institutions to
offer financial services that are limited in many communities, such as lending
to local businesses and homeowners, safe and convenient mechanisms for savings,
and transactional, cash management, and investment services. Eligibility would
be limited to banks, thrifts, and credit unions with a record of service to
their communities as measured by high loan-to-deposit ratios, a high level of
local lending, local deposits, local boards of directors, and high ratings
under the Community Reinvestment Act.
We propose to start the fund with a one-time
infusion of $30 billion from the $700 Treasury rescue package -- an amount
proportional to that which the Treasury has announced it will invest in the
On an ongoing basis, the fund would be paid for through a tax of no more than
0.5 percent of the amount of newly issued asset-backed securities -- the very
type of derivatives that have been at the core of the current financial crisis.
A long dominant theory has held that when it
comes to finance bigger is better. According to the theory, large financial
institutions are more efficient due to their economies of scale and, more
importantly, because of their ability to match lenders and borrowers wherever
they might be around the world. Banks with global reach can take capital from
wherever it is in oversupply (say, China or the United Arab Emirates ) and
direct it to places where it is in undersupply, no matter how distant (say,
Stockton, California, or East Cleveland, Ohio).
This has been the central argument for financial
deregulation over the last generation. In the late 1970s and 1980s, small banks
and thrifts lost many of the regulatory protections that prevented other financial
institutions from competing for their business. In 1994, large bank holding
companies secured the freedom to set up branch networks outside their home
states, thereby extending the typical distance between borrowers and lenders to
first, regional, and then, national, scale. At the urging of the then Federal
Reserve chairman Alan Greenspan, Congress and the Clinton administration
repealed the Depression-era Glass-Steagall Act in 1999. As the barriers between
commercial banks, investment houses, and insurance companies subsequently came
down, complex hybrid institutions emerged that put a global-scale distance
between borrowers and lenders.
Under the new financial order, anonymous
global-scale "transactional banking" replaced small-scale "relationship
banking." Small-scale banks could not compete on price. Some lacked the capital
to invest in information technology, and meeting regulatory challenges took
proportionately more effort: it could take as long as 40 minutes to get through
the paperwork simply to open an account. Big banks, taking advantage of
deregulation and their economies of scale, continued buying up community banks
or shooting out new branches and ATM networks across state lines. Internet
mortgage originators, like Lending Tree, ran television commercials mocking the
idea that a consumer would show personal loyalty to any one bank or banker.
"When Banks Compete, You Win" was Lending Tree's slogan; relationship banking was
for chumps, transactional banking was for the savvy.
As transactional banking expanded, the number
and market share of small-scale financial institutions shrank dramatically. In
1985, there were 14,000 community banks with inflation-adjusted assets of less
than $1 billion. Today, their number has been cut in half. Credit unions have
also experienced a decline in numbers. Because of that decline, many
communities, and especially many neighborhoods in urban America, have lost most
or all of their local depositories. Not only has this left people in many
communities with no place to open a savings account or take out a small loan
(aside from payday lenders), it has also dried up a critical source of lending
to small businesses since, according to the Federal Reserve, community banks
make nearly three times as many small business loans on a dollar-for-dollar
basis as do large banks.
With the benefit of hindsight, however, we can
see two clear facts that call into question whether global-scale finance really
is more efficient than small-scale banking. First, the new system invested the
world's savings in a spectacularly irrational manner. The money that poured
into underwriting mortgages on McMansions and tract houses in automobile-dependent,
jobless suburbs, it is now obvious, could have been more profitably invested in
just about anything else -- in, for example, rebuilding America's crumbling
infrastructure, converting to sustainable energy sources, or constructing
affordable rental housing near good jobs and schools.
In contrast, small-scale financial institutions
generally avoided subprime lending and related derivatives, concentrated on
traditional mortgage and small business loans, and today are in comparatively
good shape. Though vulnerable to a downturn in the economy, with few exceptions
they appear to be resistant to the financial contagion striking down larger
institutions. So is bigger really better?
The second clear fact that emerges with
hindsight is that it was the lack of a relationship of mutual interest between
lender and borrower that was at the heart of the breakdown in global finance.
All the different players in the system, from mortgage brokers to investment
banks peddling "asset"-backed securities had little interest in whether
consumers could actually afford their debt.
Unlike a traditional community bank, for
example, few lenders held on to even some of the mortgages they wrote. Nor did
they depend on deposits from the same people to whom they made loans. Instead,
most of their money was made on fees. When faraway funding sources without any
understanding of who or what they're funding substitute for local depositors,
when loans can be sold without effective recourse, when borrowers are told not
to worry about repayment because never-ending refinancing will be available,
In traditional small-scale banking, by contrast,
there is a mutuality of interest between borrower and lender. This mutuality
has both a soft and a hard side. On the soft side, small-scale banking means
that savers, borrowers, and lenders all have a heightened ability to judge each
other's character and to hold each other accountable. They are all members of a
community and, as such, subject to social pressures to act responsibly. George
Bailey didn't write loans containing improvised explosive devices in part
because he saw his customers regularly around Bedford Falls and knew his
thrift's business depended on his good reputation. His customers, in turn,
would face the opprobrium of their neighbors if they walked away from their
In small-scale banking, borrowers and lenders
also know each other's prospects better than borrowers and lenders on opposite
sides of globe. Put another way, small-scale banks are rich with what Federal
Reserve Chairman Ben Bernanke calls "informational capital," which they develop
through "gathering relevant information, as well as by maintaining ongoing
relationships with customers."
Or as the Federal Reserve Bank of Dallas put it
with more prescience than it probably realized in a 2004 report: "While lending
decisions have increasingly relied on data-rich statistical analyses, in many
cases the most relevant indicators regarding the creditworthiness of individual
small businesses still take the form of firsthand information gained through
close lender-borrower relationships."
George Bailey put it even better in his
clinching argument to his panicked depositors in It's a Wonderful Life. The residents of Bedford Falls could rest
assured that their money was safe, he said, because they knew each other:
"Well, your money's in Joe's house. That's right next to yours. And in the
Kennedy house, and Mrs. Macklin's house, and a hundred others. Why, you're
lending them the money to build, and then, they're going to pay it back to you
as best they can."
High levels of informational capital also mean that
default rates are lower than they otherwise would be, as proven by the ability
of faith-based and other tight-knit credit unions to offer payday loans at
nonusurious rates. Large stocks of informational capital also mean that lending
based on character becomes possible, so the bright young man or woman with a
strong business plan doesn't get turned down just because his or her proposed
business doesn't have exactly the debt service coverage expected.
As the Federal Reserve notes, "Locally focused
community banks have a clear advantage at assessing the creditworthiness, and
monitoring the ongoing condition, of small and medium-sized businesses. These
loans are customized to reflect the idiosyncrasies of these borrowers, and
cannot be ‘put in a box' for credit-scoring and securitization."
There is also a harder side to the mutuality we
are proposing to restore between borrower and lender by encouraging small-scale
banking. Institutions that largely depend on depositors to whom they also make
loans have strong financial incentives to avoid predatory lending and to
inculcate thrift in its broad, full meaning. Such institutions need their
customers to strike the right balance between saving and borrowing, because
otherwise the institution either falls short on deposits or gets stuck with too
This is why, in the past, banks put so much
effort into promotions such as "Thrift Week," a national institution which,
older readers will remember, started each year on Benjamin Franklin's birthday
until it petered out in the 1960s. It is why even into the 1970s, banks and
thrifts would offer you a toaster if you opened a savings account, and why they
tried to inculcate thrift in youngsters through school banking programs. Banks,
to a much larger extent than today, only thrived if their customers did as well
because they needed customers who both saved sufficiently and were not ruined
Small-scale financial institutions also a have a
much deeper mutuality of interest with the communities they serve than do
distant bank holding companies, much less national payday lender chains and
mortgage originators. If the local economy goes down, so most likely does the
local community bank because it does no business elsewhere. This relationship
makes small-scale banking more vulnerable to local downturns, to be sure, but
historically it has also created a virtuous spiral in most communities. Local
bankers have long played a self-interested role in bringing their town's
business community and civic groups together to solve common problems, thereby
helping to preserve and build the social capital needed to bring prosperity.
In a Grant Thornton survey of community bank
chief executive officers conducted in 2001, almost all reported participating
in civic groups (94 percent) or their local chamber of commerce (92 percent).
More than half reported that their banks supported local relief efforts and gave
special help to low-income segments of the community.
The absence of civically engaged local bankers is a growing problem in the many
parts of the country where sweeping bank consolidations have put most banking
business in the hands of a few giant institutions headquartered far away, and
where responsible community banks and credit unions have been further weakened
by payday lender franchises that have become more common than Starbucks or
None of this is to say that small-scale banking
is virtuous in every respect. In the past, if you couldn't form a good
relationship with your community's bankers -- perhaps because you were from the
wrong ethnic group, or just unpopular -- you were often out of luck. Community
banks have frequently been clannish in choosing their customers. They have also
been known to take in deposits from customers in poorer neighborhoods while
reserving their loans for customers in richer neighborhoods.
However, public policy has ensured that
community banks are investing in their own communities. For three decades
before the current financial crisis, for example, the Community Reinvestment Act
nudged banks large and small into lending in areas that were previously
"redlined" -- that is, avoided by banks. (Although some conservatives have
recently been eager to tar the Community Reinvestment Act as being responsible
for the current crisis, numerous studies have shown that the overwhelming
number of bad subprime loans were made by financial institutions not covered by
Moreover, even without federal regulation,
small-scale banking has always offered an opportunity for excluded groups to help
themselves in the face of discrimination. In 1913, for example, there were more
than 200 "immigrant banks" -- including 55 for Italians, 22 for Germans, 16 for
Poles, and 6 for Jews -- in Chicago alone.
Many such immigrant banks survive today and have since shed their exclusivity.
Suburban Baltimore's Madison Bohemian Savings
Bank, for example, no longer limits its loans to the Bohemian farmers of Hereford county -- or
even to Bohemians.
What policy levers are available to encourage
the growth of responsible, small-scale financial institutions? One, obviously,
is continued regulatory crackdown on predatory lenders. Close the predators
down, and more space will be created for traditional financial institutions
dedicated to thrift and mutuality of interest. When Washington, D.C. finally
shut down payday lending, local credit unions saw an upsurge in business.
The creation of national standards for
mortgages, credit card contracts, and other loan products would also help level
the playing field between responsible and irresponsible lenders. Columbia Law
School's Ronald Mann has suggested that credit card contract terms be
standardized so as to limit competitive differences to a small set of clearly
identified and relatively easy-to-comprehend terms (the interest rate and
The behavioral economists Michael S. Barr, Sendhil Mullainathan, and Eldar
Shafir have suggested that all mortgage borrowers be first offered a 30-year
fixed rate mortgage or similarly safe adjustable rate product. Turning down one
of these products in favor of a more complex loan would require especially
clear and explicit disclosures. If such disclosures were not made, the borrower
could use the failure as a defense against foreclosure if an alternative loan
turned bad. They have made similar suggestions regarding credit cards, like a
default payment plan that would pay off the debt in a reasonable period of
These are important steps toward restoring
responsibility in the consumer credit markets. However, they do not directly
address the breakdown of mutuality between borrower and lender, which is the
ultimate source of the financial system's breakdown and the problem that the
small-scale banks and credit unions can best fix.
To increase the number of small-scale financial
institutions, we have to address their biggest challenge, which is access to
patient capital. They need funds that can be leveraged eight or ten times over
to make good loans in the community -- at rates and terms that generate a
reasonable, if not a spectacular, rate of return. Badly burned by losses on
Wall Street and their experience with exploding mortgages, many Americans are
already redirecting their savings to insured deposits and seeking as well to
forge a personal relationship with their bankers -- trends that bode well for
community banking. Still, a robust community banking sector requires funding
beyond local deposits.
Even purely mutual institutions, which are owned
by their customers -- like the traditional mutual savings bank or a credit
union -- need access to funding sources beyond their deposits in order to
maintain even a modest return. This is primarily because of imbalances between
the geography and timing of deposits and the demand for loans. Institutions in
lower-income and smaller markets find it particularly difficult to fund
themselves exclusively with local deposits.
There are essentially five ways a bank or credit
union can expand its ability to lend funds beyond those provided by local
customer deposits: raising deposits outside the local area, borrowing against
assets (using the loans it holds as collateral), selling loans, earning income
from other sources such as fees, and raising more equity capital from
investors. A major challenge facing community banks is whether they can access
these sources while retaining their community connection.
Raising nonlocal deposits. Raising
deposits beyond the local area has always been difficult and expensive for
community banks. This has been mitigated to some extent by the advent of the Internet
and, perhaps more importantly, by the Certificate of Deposit Account Registry
Service. The CDARS interbank network allows some 2,500 banks, many of them
small, to attract insured deposits of up to $50 million while retaining a
relationship with the depositor, rather than sharing it with other banks and a
broker, as is the case with traditional brokered deposits. 
Although some banks have been successful at raising long-term, relatively cheap
deposits this way, others have found out-of-area deposits
to be short term, more expensive than those raised at home, and not available
to institutions that are under financial stress. 
Borrowing against assets. Community
banks and credit unions have access to the Federal Home Loan Bank system, as
well as to other sources of secured wholesale funding, which enable them to
borrow against high-quality assets. Because of the Home Loan Bank system's
status as a government-sponsored enterprise, the cooperative nature of the
system, and economies of scale, Home Loan Bank advances are cheaper than other
forms of borrowing, although generally more expensive than deposits gathered
from local customers. However, while this borrowing resource has held up
relatively well through the current credit problems, there are limits on its
use, including cost, availability of acceptable collateral, and regulatory
pressure to restrain it (in part because Home Loan Bank advances reduce assets
available to the FDIC in the event of a bank failure).
Selling loans. Loan sales, meanwhile,
have become substantially more difficult in this environment. This is
especially the case with sales of home loans made to any but the most
conservatively defined perfect customers. The private secondary market has
largely shut down, and Fannie Mae and Freddie Mac, even in conservatorship,
have put in place restrictions that make sales of the moderate-size mortgages needed
by the bulk of the population difficult. It is particularly hard for a
community bank to make a loan sale to Fannie and Freddie if it wishes to retain
the payment, or servicing, relationship with its local customers, as many do
and more should.
Fee income. Fee income is an area
where community banks have consistently lagged larger institutions. In part,
this is a function of the "originate and hold" -- or at least the "originate
and service" -- strategy that builds the mutuality of interest between lenders
and borrowers. But it is also due to the laudable fact that community banks
have been significantly smaller players in the credit card market, where
frequently abusive fees can account for much of the revenue.
Equity. The biggest problem facing
small banks today, however, is attracting long-term equity capital from
stockholders. Most small banks are privately held, and even for those that are
not, interesting the public in banks stocks is not easy.
This problem could get worse for small banks if, after all the bailouts, just a
few giant financial institutions control most banking. This outcome now seems more
likely, especially since it has become government policy, under the Treasury's
Troubled Asset Relief Program (TARP), to favor large institutions with the
lion's share of equity infusions.
Small banks have always needed a proportionately
higher level of equity because of their higher cost structure, their lack of
diversification, and (for the majority that are either mutually owned or
closely held) their lack of easy access to the capital markets. In the current
market environment, particularly with reduced access to loan sales, community
banks and credit unions that want to step up their lending need sources of
additional capital. Equity is important both as a risk cushion and as the basis
for leverage. Even conservative small banks leverage each dollar of equity into
about $7 of loans. For communities banks serving low-income areas, accessing
additional capital can be particularly difficult, but the additional
opportunity to lend generated by the equity is especially important.
Community Banking Trust Fund
To solve these obstacles to greater mutuality of
interest between borrowers and lenders, we propose the establishment of a
Community Banking Trust Fund. As previously stated, the fund would make equity
investments in small-scale depository institutions that need patient equity
capital to serve their communities effectively. In addition, the fund would
make nontaxable technical assistance grants to cover critical investments in
such areas as information technology and disaster recovery.
Currently, some small-scale banks and credit unions
deeply involved in community building have access to equity capital and grants
through the Community Development Financial Institutions Fund, which provides a
useful model. Unfortunately, its resources are subject to the whims of the congressional
appropriations process and cumbersome to access. Moreover, the CDFI Fund has
never had an appropriation in excess of $120 million, making it far too
modestly funded to make much of a difference.
By contrast, the Community Banking Trust Fund
would be of a size commensurate with the sector's needs and have a stable,
dedicated source of funds. Although qualified institutions would not have to
compete with each other to obtain these funds (dividend payouts and other forms
of return on investment, for example, would be standardized) equity infusions
would flow only to those that demonstrated their need for additional support to
enable them to continue to serve their communities effectively.
These equity infusions would be structured to
take into account the corporate form of the receiving institution, whether a credit
union, a mutually owned bank, a Subchapter S corporation, a regular corporation
that is privately held, or a publicly traded entity. For example, banks in
corporate form might sell the government nonvoting common stock (with the
requirement that no dividend be paid to other shareholders unless the
government were paid a dividend at the same rate). For Subchapter S banks, the
dividend payout to the government would be modified to take into account the lack
of a tax at the corporate level. Mutuals and credit unions could receive net
worth certificates, which would count as equity but pay a set interest rate.
Only banks and credit unions that won formal
designation as community banks or credit unions would be eligible to
participate in the Community Banking Trust Fund. Currently, "community bank" is
an industry term that has no specific legal definition.
Generally, it refers to smaller, local banks that concentrate on personal
service. Some cater principally to upscale citizens and small business owners
who demand personal attention. Others, typically known as community development
banks, have social missions and are deeply involved in local community building
efforts. But there are also banks with as much as several billion dollars in
assets and far-flung branch networks that call themselves community banks. Some
of these, especially those made up of formerly independent banks that retain
their identity, still are. Others use the moniker mainly because they once were
community banks and the phrase has a nice ring to it.
Under our proposal, to become a federally
designated community bank or credit union, and therefore eligible for equity
investment from the Community Banking Trust Fund, an institution would have to
remain small. We define small as holding assets of no more than $5 billion.
Participating institutions would also be required to seek out local deposits,
and concentrate the vast bulk of their lending (say, 70 percent) on home
mortgages, multi-family mortgages, and consumer, business (including
nonprofit), and local government loans within a limited geographic area.
They would also have to show demonstrable
investment in their local community through high loan-to-deposit ratios,
coupled with a high market share of local depositors (taking into account the
ability of the community to provide deposits). That means service to the entire
community, including minorities, immigrants, and those of modest means. No
country club banks need apply. Other criteria would include having board
members who are of the community and the performance of community service by
officers and employees of the bank.
Criteria such as an outstanding rating under the
Community Reinvestment Act
or the "Development Lending Intensity" and "Development Deposit Intensity"
metrics created by the National Community Investment Fund could also be used.
We expect that as the system evolved additional metrics would be developed,
including in particular measures specifically appropriate to credit unions.
How much money are we talking about? The
Treasury Department has announced that it will invest up to $250 billion in
preferred stock in banks and thrifts, at the rate of between 1 percent and 3
percent of an institution's risk-weighted assets. (This is the dollar amount of
assets such as loans, increased or decreased according to regulatory standards
to reflect their riskiness.)
As of June 30, 2008, total risk-weighted assets of banks and thrifts with under
$1 billion in assets were about $1.1 trillion. Thus, banks and thrifts of this
size could conceivably receive between $11 billion and $33 billion from the Treasury's
program. As of June 30, 2008, the assets of all credit unions totaled $740
billion, with $328 billion of that in credit unions under $500 million in
assets. Using the same analysis, if credit unions were eligible for the
Treasury program, their share would be between $7 billion and $21 billion. In
comparison, each of several large banks got infusions of $25 billion.
Another way to estimate the initial cost of
supporting small institutions in a manner commensurate with their larger
brethren, while taking into account their need for higher equity ratios, is to
look at what it would take to bring the relevant group to a capital ratio of
13. This is in line with traditional levels for healthy, smaller institutions.
Based on the June 30 data, it would take a total of $73 billion to bring the
aggregate capital of all banks with less than $5 billion in assets and all credit
unions to this level.
However, this is a huge overestimate of the
amount that would actually be needed to support true community banking
effectively. First, not all banks and thrifts with under $5 billion in assets,
and not all credit unions, will qualify for public investment under the
standards set out above. Second, of the group that qualifies, not all
institutions will need the money or will apply for it. Many may feel
comfortable with a lower equity ratio, or uncomfortable with any sort of government
equity ownership. And some institutions (including some of those that ceased
being real community banks and invested in speculative real estate far from
home) may be so troubled that a government investment would be unwise.
To get a more realistic (though still high-end)
estimate, we assume a take-up rate of 50 percent for banks and thrifts of under
$1 billion in assets and for all credit unions. We also assume a take-up rate
of 20 percent for banks and thrifts in the $1 billion to $5 billion category, a
greater proportion of which would have difficulty qualifying as community
banks. On this basis, the Community Banking Trust Fund would need a one-time
infusion of about $30 billion.
How much would this cost on an ongoing basis?
The needed level of support can only be approximated. As discussed above, most
small institutions are doing well. But let's assume that each year the group in
the aggregate would need about one-half of 1 percent of assets to ensure its continued
ability to meet community needs. Assuming take-up rates remain constant, that
works out to a total annual cost of about $7 billion.
Where would this funding (as well a much smaller
amount for grants for technology upgrades and similar needs) come from? We
propose that on an ongoing basis, the funding for both equity and grants come
from a tax on securitized loan transactions, which are the type of transactions
that have the least mutuality between borrower and funder, the lack of which
led to the current crisis.
Issuance of asset-backed securities peaked at
about $3.2 trillion ($2 trillion of mortgage debt and $1.2 trillion of other such
securities) in 2006. This market has declined substantially since, and will
probably be depressed for some time. Looking back to the beginning of the recent
bubble, in 2001 issuance of asset-backed securities totaled about $2 trillion
($1.6 trillion of mortgage debt and about $400 billion of other such securities).
A tax of about one-half of 1 percent (0.005) of the dollar amount of asset-backed
securities issued annually would be more than sufficient to finance the
Community Banking Trust Fund to a level that would meaningfully check the
financial service sector's overall tendency toward consolidation and lack of
The notion that big market players with
government backing should support those that are more community-oriented is
hardly unprecedented. The Federal Home Loan Banks have long been required to
set aside 10 percent of their annual net income to support the Affordable
Moreover, since the summer of 2008, Fannie Mae and Freddie Mac have been
required to contribute an amount equal to 4.2 basis points (0.042 percent) of
the principal amount of mortgages purchased to support affordable housing,
including housing produced by community development financial institutions.
Collecting such a tax should not be difficult.
The Securities and Exchange Commission collects fees on securities registration
(as well as on sales on exchanges and in the over-the-counter market), and the
system could be adapted for these purposes also.
The cost of administering the Community Banking
Trust Fund will likely be modest. The administrative budget for the Community Development
Financial Institutions Fund is only about $14.7 million. The National Credit
Union Administration, with oversight of about 8,000 credit unions, gets by on
about $150 million. We assume the Community Banking Trust Fund could be
effectively administered for well under $100 million annually.
Virtues of Small-Scale Banks
As we foster small-scale banking we must avoid past
regulatory errors, such as the infamous Regulation Q that prevented thrifts and
commercial banks from paying market rates for deposits and led to the savings and
loan crisis. Too much coddling and protection for small-scale bankers could
also erode their competitiveness and spirit of enterprise, which became a big
problem in the 1960s and 1970s, and remains so to a lesser extent today. More
community bankers need to learn to apply information technology, which
fortunately is becoming more affordable, to lower the cost of their operations
At the end of the day, it is also clear that
small-scale banking won't work unless Americans regain the savings habit. Such
a change in behavior will have to happen in any event, as rapid population
aging in creditor nations, unsustainable trade imbalances, and other factors
reduce the amount of foreign capital Americans can cheaply import. Moreover,
small-scale banks can help to foster a return to the thrift ethos. They can do
this by bringing back banking and credit union services to areas where
residents are currently "unbanked" and by promoting financial education and
A final argument for encouraging small-scale
banking looks to the near future. The ongoing credit crisis had its roots in
the destruction of the mutuality of interest between borrowers and lenders.
That mutuality is now becoming further eroded by the even greater consolidation
of financial services institutions that is emerging from the crisis itself. By
the fall of 2008, just three institutions, Citigroup, Bank of America, and J.P.
Morgan Chase, held more than 30 percent of the nation's deposits, while also
holding 40 percent of bank loans to corporations.
We should not be surprised if large banks wind up using much of the public
money they are now receiving to buy up smaller banks. When the credit crisis is
past, just a handful of "banks," for want of a better term for these
hydra-headed goliaths, will control most of the market.
Our proposal for a Community Banking Trust Fund
will cost money. But funding will come by taxing, and therefore discouraging, those
forms of transactional, securitized borrowing that led to the current crisis.
Moreover, making the Community Banking Trust Fund part of our new regulatory
architecture will help redress the long-term distortions caused by the massive
federal investments now flowing from the Treasury to big banks -- some of them
the very institutions responsible for our current troubles.
Since the Progressive Era and before, community
banks, thrifts, and credit unions have served customers in a manner that
promoted mutuality while also serving as a check against monopoly finance in
the hands of a few money-center banks. Before the conflagration of the global
financial system brought on by predatory subprime mortgage lending practices
and other irrational uses of the world's savings, singing the virtues of
small-scale banks might have seemed nostalgic and romantic. After the painful
bursting of three financial bubbles in a decade, however, paying attention to
those virtues is both essential and hardheaded.
In It's a
Wonderful Life, George Bailey got to see how much poorer his world would be
if he hadn't existed. Today, a world that has passed him by looks ugly indeed.
 Mark Landler, "U.S. Is Said
to Be Urging New Mergers in Banking," New York Times, October 21, 2008.
 The Treasury has announced that it will invest an amount equal to between 1 percent and 3 percent of risk-weighted assets—the assets on a bank’s balance sheet weighted to reflect the assets’ riskiness under regulatory capital rules—but no more than $25 billion in individual banks. The first investments, including three at the $25 billion level, went to nine very large banks. The Treasury Department has also urged small banks to apply for Treasury preferred stock investments, and on November 17, 2008, Treasury announced a special program for banks that are not publicly traded. The application deadline for this program is December 8. http://www.treas.gov/press/releases/reports/term%20sheet%20%20private%20.... There is also a special program for banks serving low-income communities that are certified as Community Development Financial Institutions, who will not be required to issue warrants. http://www.treas.gov/press/releases/reports/faq%20111708%20%20private.pdf.
It is unclear how many smaller banks will choose to apply. The new program does not apply to Subchapter S corporations, for whom the program’s restriction on dividends (which are taxed at the shareholder, rather than the corporate, level as in a standard corporation) may make participation undesirable (see Bonnie McGeer, “Mutuals, Sub S Banks to Treasury: What About Us?” American Banker, October 22, 2008, 1), nor to banks in mutual ownership form. Making sure small banks are not disadvantaged with respect to deposit insurance is also critical. The recent actions to both temporarily increase the deposit insurance level to $250,000 for all banks and credit unions, and to remove the cap for non-interest-bearing (mainly business) accounts in banks until December 31, 2009, are important steps in this regard.
 For example, ShoreBank in Chicago has raised over $20 million in deposits in about a
year through its high yield savings account, an Internet account that funds its
Rescue Loan program to refinance Chicago
borrowers out of bad mortgages. ShoreBank has been able to hold and grow these
deposits even while lowering the interest rate paid from an initial 5 percent
to the current 3.5 percent (http://shorebankdirect.sbk.com/).
 The FDIC has proposed raising
insurance premiums for institutions that have high levels of secured
liabilities, including Federal Home Loan Bank advances. See Federal Register 73, no. 201, October
16, 2008, 61570.
This difficulty in
selling loans is critically important, as no community bank funded primarily
with deposits can take the interest rate risk of making the 15-year or longer
fixed-rate loans that Americans are once again learning to value. While in time
this situation will probably relax some, long-term support of community banking
requires a continuous and reliable secondary market for these loans. That
includes loans made specifically to new homeowners, those in neighborhoods that
have been the focus of government support, and loans made to a broad swath of
Americans of moderate income across the country.
their ultimate fate, Fannie Mae and Freddie Mac must, during this period of
crisis, enhance their essential core function of buying well-designed,
consumer-friendly loans from community banks and credit unions. As in the past,
Fannie and Freddie must set the standards for high loan quality, while being
creative in helping banks make prudent loans for both rental and owned housing.
In contrast to current practice, in which a premium is paid when the servicing
relationship is transferred out of the bank making the loan, banks should be
strongly encouraged to retain the servicing relationship. In the short term,
the Federal Housing Finance Administration, which regulates Fannie and Freddie,
could immediately direct Fannie and Freddie to accelerate their purchases and
improve their pricing.
 Others are in mutual form,
which, as with credit unions, means they do not have stock to sell, but rather
obtain their capital by holding on to retained earnings, a very slow way to
build a capital base.
 Although we present it here
as a separate entity, the Community Banking Trust Fund could be also structured
as a program within the CDFI Fund. This has the advantage of building on a
structure already in place that has extensive experience with financial
institutions of all sizes and types.
 "Community credit union"
is, in contrast, a designation conferred by the National Credit Union
Administration. Whether it is being conferred too broadly is a matter of debate
that should be incorporated into the discussion about the community bank
 Contrary to assertions by a
group of conservative critics, the Community Reinvestment Act was not the cause
of the ongoing financial crisis. See Michael S. Barr and Gene Sperling, "Poor
Homeowners, Good Loans," New York Times, October 17, 2008; and Robert
Gordon, "Did Liberals Cause the Sub-Prime Crisis?" The American Prospect online, April 7, 2008, http://www.prospect.org/cs/articles?article=did_liberals_cause_the_subprime_crisis. A recent study finds that
default rates on subprime mortgages made by traditional banks, often in
response to the Community Reinvestment Act, have performed far better than
those made through brokers. See Lei Ding, Roberto G. Quercia, and Janneke Ratcliffe,
"Risky Borrowers or Risky Mortgages," Center for Community Capital, University of North Carolina, October 2008, http://www.ccc.unc.edu/documents/RiskyBorrowers_RiskyMortgages_1008.pdf.
 Treasury investments are,
however, limited to a maximum of $25 billion per institution.
 In the aggregate, bringing
the 7,777 banks and thrifts with under $1 billion in assets to a 13 percent
capital ratio would require approximately $35 billion; the 481 between $1
billion and $5 billion would require approximately $21 billion; the 7,972
credit unions would require about $17 billion. Because these are aggregate
numbers, they do not reflect the fact that a limited number of primarily small
entities already have more than 13 percent equity; in practice the equity in
those entities will not cross-subsidize the entities with less equity.
 This consists of about $4
billion for the smaller banks, $1 billion for the banks with between $1 billion
and $5 billion in assets, and $2 billion for the credit unions.
 Section 1331 of the Housing
and Economic Recovery Act of 2008, Pub. L. 110-289. Initially, the funds will
be used to support the Hope for Homeowners program, but starting in 2010 they
will be available to Community Development Financial Institutions and others
for affordable housing. The Housing Trust Fund and Capital Magnet Fund will
also get a portion of profits on the sale of assets under the bailout
 Binyamin Appelbaum,
"Wachovia Is Sold As Depositors Flee," Washington Post, September 29, 2008.
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