Forget Wall Street -- here's an idea to help U.S. banks

The presidential candidates on both sides of the aisle have taken turns heaping scorn on Wall Street, a perennially popular target on the campaign trail. But there is one part of the financial industry absent from the critique that in many ways is even more vital to the U.S. economy: community banks.

Small banks play an essential, if often unrecognized, role in the economy. Over time, they become experts in local business conditions and the types of specialized industries that operate in their area, and they develop important relationships with local businesses. This allows small businesses to get loans they wouldn't be able to get from a large, national bank. Community banks also fund new small business ventures, and they are an important source of liquidity and capital during economic downturns.

The ability to get a loan during a recession can make the difference between a local business surviving or not. Applied to all the small banks in all the towns in the U.S., lending to small local businesses can have a large impact on how well communities weather an economic storm.

The main reason to omit smaller banks from a demand for financial reform: The financial crisis was not caused by community banks; the largely unregulated "shadow bank" system, with its "too big to fail" financial institutions, bears this responsibility. But while community banks didn't cause the financial crisis, they were impacted nonetheless.

According to the Federal Reserve Bank of Philadelphia, the number of government-backed commercial banks and savings institutions shrank from roughly 8,500 in late 2007 to some 6,900 lenders as of mid-2013.

When these banks fail, depositors are insured through the FDIC, but there are still economic consequences. Important sources of local business expertise are lost, and longstanding business relationships are broken. As a result, the chance that a business connected to the bank will fail go up, the chance that a new small business will launch goes down, and the local economy is hurt. Although the entry of new banks into the market can partially offset this cycle of decline, far few lenders started during and after the Great Recession, while it takes time to regain rebuild relationships.

The problem facing community banks, and this goes beyond the recession, is that they tend to specialize in particular types of loans. A local bank might, for example, have a large fraction of its loans is a particular type of agricultural commodity or a particular type of business. This can lead to big problems if that particular commodity has a large price drop, or if the particular line of business experiences trouble and they have trouble repaying their loans (this is known as "asset accumulation").

Thus, while community banks provide benefits to local communities, they also come with extra risk due to their tendency to specialize in particular types of loans.

What can be done to reduce the risk of bank failure while preserving the benefits to the local community? There are two lines of attack. First, increase the capital requirements of banks based upon their degree of asset concentration. Surprisingly, as this paper from a Federal Reserve official notes, banks that are riskier due to asset accumulation do not hold any more capital in reserve as insurance against problems than do banks with lower asset concentrations. If banks won't so this voluntarily, and that appears to be the case, then regulation can put this safeguard in place.

My preferred solution is to encourage these banks to diversify their loan and financial asset portfolios to reduce the risk (if they are forced to hold more capital if they don't diversify, this will happen in part as a result of such a regulation). Out-of-area loans are one possibility, though this is risky since it involves loans that are outside of the bank's traditional expertise, and diversifying security holdings can also diversify risk if the securities are attached to industries that typical fare well when the bank's area of specialization fares poorly. The opportunities to do this are limited, but to the extent that's possible it can reduce the need to hold more capital, which reduces a bank's ability to make loans to the local community.

Whatever the answer, the first step is to recognize the problem, in particular the crucial role that community banks play in local economies, and how that can be endangered when a recession hits or when a particular types of business experiences trouble. Big banks have received most of the attention in recent years, but small banks also play a vital role too -- it's important that we do our best to fix this vulnerability before the next recession hits.