It's a Wonderful Life
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When Paul Hudson, the chairman and CEO of Broadway Federal Bank in Los Angeles, speaks of the current financial crisis, he sounds altogether placid. “Its going to be difficult, because everybody participated in this low-cost-credit, high-value-asset scenario,” he says. “But Im not overly stressed.” It helps that his own bank is doing fine. Broadway Federal, founded in 1946 to provide loans to the growing African American community of Los Angeles, is a small institution with five branches located in middle-class, largely black neighborhoods of the city. It has eighty-four employees, assets of $390 million, and a loan portfolio divided more or less equally among single-family homes, apartment buildings, churches, commercial real estate, and small businesses.

Aesthetically, Broadway Federal’s branches are more evocative of 1972 than of 1946—copious concrete, cheap terrazzo, fluorescent lights, clunky logo. But in 2008, an old-fashioned look—even one from the ’70s—can be an advantage, for it suggests old-fashioned banking. While Broadway Federal may have been less adventurous or less profitable than some of its competitors over the past few years, today it enjoys the traditionalist’s compensation of being both sane and solvent. In fact, according to data from the Federal Deposit Insurance Corporation, Broadway enjoys a substantially higher return on equity and assets than J. P. Morgan does. (It also has a lower proportion of nonperforming loans.)

Broadway Federal’s story isn’t exceptional. Easily overlooked amid the crisis of big banks today, small-scale financial institutions are, for the most part, holding steady—and sometimes even better than steady. According to FDIC data, the failure rate among big banks (those with assets of $1 billion or more) is seven times greater than among small banks. Moreover, banks with less than $1 billion in assets—what are typically called community banks—are outperforming larger banks on most key measures, such as return on assets, charge-offs for bad loans, and net profit margin.

One reason community banks are doing so well right now is simply that they never became too clever for their own good. When other lenders, including underregulated giants like Ameriquest and Countrywide, started peddling ugly subprime mortgages, community banks stayed away. Banking regulations prevented them from taking on the kind of debt ratios assumed by their competitors, and ties to their customers and community ensured that predatory loans were out of the question. Broadway Federal, for its part, got out of single-family mortgages when they stopped making sense. “A borrower comes and asks, ‘Do you do interest-only, no-down-payment, option ARMs?’ ” recalls Hudson, with a chuckle. “No!” The bank focused instead on expanding its reach to niche borrowers, such as local churches.

Today, however, even as many financial institutions are refusing credit, Broadway Federal quietly continues to extend it. One recent recipient was a nonprofit called the Domestic Violence Center of Santa Clarita Valley, which needed $40,000 as a bridge loan in the midst of state budget holdups. Nicole Shellcroft, the executive director of the center, says that no large bank had been willing to lend the money. Under the terms worked out with Broadway Federal, though, the domestic violence center was given a three-month loan for a fee of $900 in interest. “Our board was really happy with the terms,” says Shellcroft. “It was actually better than a line of credit.” Beyond offering special loans, Broadway has been attracting customers by being accommodating and personalized. “I can proudly take in my money daily, deposit it, and get access to my money directly,” notes Angela Dean, founder of DeanZign, a local fashion company. Dean recently switched over from Washington Mutual to Broadway Federal for her business checking. She’s not alone. In 2007, before the crisis had properly struck, Broadway Federal experienced $7 million in net deposit growth. This year, as of June 30, says Hudson, net deposit growth was at $25 million.

Community banks come in different forms. Some are “country club” banks for the wealthy. Others are “community development banks,” such as Chicago’s South Shore National Bank, formed as part of an idealistic effort to serve the “unbanked” in blighted neighborhoods. And many, like Broadway Federal, are small-scale banks, credit unions, and thrift institutions, often with origins back in the Progressive era and earlier, when working-class men and women began pooling their savings together and making loans to one another in order to overcome the discrimination they faced from established banks. What all of these varieties have in common are a connection to a small geographical area and a personalized approach to customers. Whereas large banks rely on “transactional banking”—in which formulas and set calculations govern lending decisions—community banks rely on “relationship banking,” in which all sorts of personalized considerations enter into the picture. This allows people like Nicole Shellcroft to secure prudent loans that might otherwise be out of reach. “That’s what a community bank does,” says Hudson, who is the grandson of one of the bank’s founders. “It sits down with you and works it out.”

Today, with the world’s system of anonymous high finance in crisis, small-scale community banks, thrifts, and credit unions—all regarded until recently as vestigial players in a new world of global consumer finance—are setting an important example. If federal policies were in place to provide proper support to small-scale financial institutions, Washington could do a lot to alleviate the country’s most serious economic problems: its lack of savings, its runaway consumer debt, its dwindling supplies of social capital, and its vulnerability to financial contagion brought on by Wall Street excess. By encouraging thrift, responsibility, and a sense of community, small-scale financial institutions could play a leading role in helping us dig out of this financial meltdown—and in helping to fend off the next one.

Big Banks, Big Bust

For decades now, most experts have argued that in finance, bigger is better. With their economies of scale, larger institutions are more efficient, goes the reasoning. They can match up lenders and borrowers all about the globe, tapping into places where money is piling up (like China or the United Arab Emirates) and directing those funds to borrowers in places where money is scarce (like Stockton, California, or East Cleveland, Ohio).

Such reasoning has held sway for a generation. The Monetary Control Act of 1980 made it easier for banks to merge, while also embracing a world in which middle-class Americans would put more and more of their savings into mutual funds and money market accounts. Another major change occurred in 1994, when large bank holding companies secured the freedom to set up branch networks outside their home states. Perhaps the biggest shift came in 1999, when (at the urging of Federal Reserve Chairman Alan Greenspan) Congress and the Clinton administration repealed the Depression-era Glass-Steagall Act, which had placed barriers between different kinds of financial institutions. After this repeal, commercial banks, investment houses, and insurance companies began to merge into complex, hybrid institutions that put ever-greater distance between borrowers and lenders.

With the shift in rules, transactional banking started to replace relationship banking. Big institutions bought up many community banks and set up new branches and ATM networks across state lines. Consumers responded favorably to the convenience of having access to everything in one place—brokerage accounts as well as traditional savings vehicles—and to being able to bank wherever they traveled.

Many small financial institutions tried desperately to
compete by getting bigger themselves, and more than a few succeeded. Meanwhile, those that stayed small faced increasing challenges. Enormous, largely unregulated institutions like Countrywide and Ameriquest—”non-bank” banks—were competing very effectively for customers. These behemoths raised their funds not from depositors, but from global capital markets, and, since they did most of their business over the Internet or through freelance mortgage brokers, they had minimal overhead. Exempt from the legal requirements to invest in the local communities that normal banks must honor, these institutions could easily have been seen as predatory. Instead, many people applauded how entities like Countrywide were “democratizing credit,” long a goal of liberal public policy.

At the same time, social attitudes subtly changed, thanks in no small measure to shrewd advertising. Mortgage originators like LendingTree ran TV commercials mocking the idea that a consumer would show personal loyalty to any one bank or banker. “When banks compete, you win,” is the LendingTree slogan.

As transactional banking expanded, the 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 is smaller by half. Many communities, especially those in urban America, have lost most or all of their local banks. 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. (Community banks make nearly three times as many small business loans on a dollar-for-dollar basis as do large banks, according to the Federal Reserve.)

Until the current crisis, many ascribed such outcomes simply to the logic of the market. Looking back, however, we can see that global-scale finance wasn’t really so efficient after all, except in the sense of being very efficient at wasting the world’s capital. Throughout this decade, the world, if not America, became awash with savings. Rising energy prices created trillions of petrodollars, while America’s continuing trade deficits left our trading partners with trillions more in surplus funds. All that money had to be invested somewhere. That somewhere turned out to be in complex and often nonsensical financial concoctions—most of them based on empires of McMansions and tract houses in remote, jobless suburbs. The easy money fueled more demand for imports, thereby keeping the global financial system in balance—
until, that is, it imploded.

Today we can see that the world’s surplus of capital could have been more profitably invested in just about anything else. (How much better to have borrowed money to repair our infrastructure, retool our industry, or promote sustainable energy!) When the going still seemed good, though, big banks took on more and more debt to stay competitive. By the end, Lehman Brothers was borrowing forty-five dollars for every dollar of its own that it was lending. Like a shark, it had evolved into a highly efficient predator that had to keep moving or perish.

Small financial institutions, by contrast, had neither the opportunity nor the incentive to imitate the large ones. Cushioned by their deposits, they could hunker down while the mortgage markets went crazy. This also meant they could get by if credit markets froze—as they eventually did. In community banks, both borrower and lender maintained a serious stake in the long-term outcomes of their transactions. For deposits, the banks kept relying on the same people to whom they made loans. Because the banks tended to hold on to their loans instead of selling them to distant investors, they took care to avoid granting loans to customers who couldn’t repay them. Social pressure also helped to stave off predatory lending. When savers, borrowers, and lenders all live in the same community, lenders don’t write loans that amount to financial crack. They know their business depends on their good reputation. Similarly, borrowers, who prize the good opinion of their neighbors, don’t easily walk away from their loans.

In small-scale banking, then, borrowers and lenders can effectively see one another. They’re rich with what Federal Reserve Chairman Ben Bernanke calls “informational capital,” and this has a stabilizing influence. As savings-and-loan chief George Bailey tells his panicked depositors in the 1946 film It’s a Wonderful Life, their money is safe because it’s being loaned out to trusted friends and neighbors: “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.”

Having an abundance of informational capital not only helps to prevent bank runs, it also keeps default rates low (which is why, for example, faith-based credit unions can afford to offer payday loans at non-usurious rates). Lending based on character also becomes possible. The bright young man or woman with a strong business plan doesn’t get turned down just for missing some lending formula ratio concocted in a faraway bank holding company headquarters by bureaucrats who know nothing of local conditions or the character of local customers. As one Federal Reserve report 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.”

A healthy relationship between borrowers and lenders can have another important effect: promoting greater savings. Without easy access to global financial markets, small banks are heavily dependent on their depositors for capital. This means they have a financial incentive to inculcate thrift, as all banks once did before America began importing so much foreign capital. Older readers will remember “Thrift Week,” an institution, sponsored by the banking industry and others, that started each year on Benjamin Franklin’s birthday (until it petered out in the 1960s). They’ll also remember how major banks used to offer customers promotional items like toasters for opening savings accounts and tried to inculcate thrift in youngsters through school banking programs. (And, indeed, some local banks in small communities still do this.) Before we began importing most of our savings, all banks needed customers who saved sufficiently and were not ruined by debt.

Naturally, being so closely tied to the fortunes of the community makes small banks more vulnerable to local downturns than large banks. But this isn’t all bad, since it gives local bankers an interest in bringing their town’s business community and civic groups together to solve common problems and find new ways to prosper. For community banks, community involvement is central. 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 special help to low-income segments of the community. Today, many parts of the country have lost their civically engaged local bankers, and this absence is strongly felt.

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 with your neighbors—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.

But public policy can do (and already has done) a lot to ensure 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 conservatives have recently been eager to tar the Community Reinvestment Act as responsible for the current crisis, the contention is ludicrous. Numerous studies have shown that the overwhelming number of bad subprime loans were made by financial institutions not covered by the act.) 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 so-called “immigrant banks”—including fifty-five for Italians, twenty-two for Germans, sixteen for Poles, and six for Jews—in Chicago alone. Many such immigrant banks survive today and have since shed their exclusivity. Suburban Baltimore’s Madison Bohemian Savings Bank no longer limits its loans to the Bohemian farmers of Hereford County—or even to Bohemians.

Taming Goliath

Perversely, even as Washington prepares to distribute rescue dollars, it is once again the big banks that stand to come out ahead. When the latest crisis shakes out, the United States may well be left with just three or four titanic entities that will not only be “too big to fail” but also excessively powerful, even if heavily regulated. Already, just three institutions, Citigroup, Bank of America, and J. P. Morgan, hold more than 30 percent of the nation’s deposits and 40 percent of bank loans to corporations.

Half of all Americans do business with Bank of America. Now, some of the big banks receiving “rescue money” from the Treasury report that they intend to use it to acquire smaller banks. Only if community banks are given a fair chance in this environment will Americans have proper, sober alternatives to being banked by Goliath. Otherwise, the distance between lender and borrower will only grow, creating even more problems in the future.

Under the Treasury’s rescue plan, some healthy small banks have the chance to apply for infusions of publicly funded equity capital. But this is a temporary, emergency measure. For the longer term, we need to ensure that the small aren’t devoured by the large and that the system as a whole remains balanced.

Community banks and credit unions don’t need a bailout, but they could use support to deal with a few serious major challenges. First, predatory lenders—the worst of the mortgage brokers, pawnshops, payday lenders, and the like—must be shut down, so that space will be cleared for traditional financial institutions dedicated to thrift and long-term relationships. (When Washington, D.C., finally shut down payday lending, local credit unions saw an upsurge in business.) Second, and more urgent, small-scale financial institutions must have readier access to capital. That means having enough funds on hand to make loans that generate a modest but reasonable rate of return. Currently, community banks are experiencing an upsurge in deposits from Americans burned by losses elsewhere, but a robust community banking sector requires long-term funding, and deposit levels, by nature, fluctuate as individual customers move their money in and out of their accounts. The best source of the funding community banks need to make long-term loans is equity capital from investors. But most small banks are privately held, and lately, convincing investors to buy bank stocks is difficult.

That’s where Washington could come in. A “Community Bank Trust Fund” could be established to provide small-scale financial institutions that met certain federal standards—in terms of size and of level of investment in the local community—with equity capital. The trust fund could purchase preferred stock in institutions that were looking for capital to grow, just as Treasury’s rescue plan is now doing for mostly large banks on a temporary, emergency basis. As with the Treasury plan, these funds would be at risk, but could also earn a healthy return for taxpayers if all goes well.

Instead of merely borrowing the money—as we are currently doing with the Treasury’s rescue plan—we could do something more fiscally responsible: tax transactional banking. Specifically, we could impose a fee on the securitized loan transactions that are at the heart of the current crisis—and use the money to invest in the Community Bank Trust Fund. In other words, every time J. P. Morgan wants to bundle up a bunch of mortgages, credit card debts, and student loans, slice and dice them into impossibly complex derivatives, and sell the paper to unsuspecting investors around the world, it should pay a tax on the transaction, with the money going to support small-scale, relationship banking.

Certainly, no one wants special coddling or protection of small-scale bankers, eroding their competitiveness and spirit of enterprise. And there is, to be sure, a useful role to be played by properly regulated global financial institutions. But friendly policies aimed specifically at community banks would be a helpful counter to several decades of bias toward large institutions. As Paul Hudson of Broadway Federal says, “The point is, people should have a choice.” They should also have a financial system that is more resistant to contagion of the sort now afflicting large banks.

Since the Progressive era and earlier, community banks, thrifts, and credit unions have served customers in a manner that has promoted community building and mutuality while also serving as a check against monopoly finance. Before the recent meltdown of the global financial system, singing the virtues of such 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 hard-headed. It’s a vital first step as we attempt to recover from years of financial abuse and excessive faith in all things large.

Phillip Longman

Phillip Longman is senior editor at the Washington Monthly and policy director at the Open Markets Institute.