The Fed is Killing Small Banks

Today, four years since the official bottom of the 2007-2009 recession and financial crisis, you can add a surprising voice to the list of those still waiting for a recovery: America’s small banks. As CNNMoney’s Stephen Gandel notes, the banking recovery has been uneven; small lenders are still in trouble, and some continue to fail even as loan quality at larger institutions has rebounded sharply. The U.S. banking sector is becoming a two-class system: big banks are getting bigger, and small local banks are dying. Large banks are driving a Wal-Martization of the banking sector. As with Wal-Mart, the implications for Americans’ standard of living are not good.

Gandel leaves the rails when he speculates that bank capital regulations designed to protect the sector’s safety might be the cause of small banks’ malaise. Capital requirements are window dressing over the intractable structural problems of fractional-reserve banking. To the extent capital requirements reduce reliance on taxpayer-guaranteed deposit insurance, they’re a good thing for bank sustainability. Of course, twiddling with capital requirements by a point or two will not be what saves the banking system. Only a move toward a full-reserve model, where banks earn money primarily from transaction clearing services and lending their own funds (rather than gambling with customer deposits) will do that.

So, what’s killing small banks? The Federal Reserve.

During this crisis, the Fed realized that only insanely low mortgage rates would support the property prices of 2006-2007. So, it set about creating them, in a bid to encourage the sort of unsustainable, home-equity-driven spending we saw in 2006-07. The Fed’s Treasury purchases failed to push down mortgage rates, and instead drove up stock and corporate bond prices. So, the Fed resorted to a policy it never had before: it began buying mortgages guaranteed by Fannie Mae and Freddie Mac, pouring hundreds of billions of dollars directly into the housing mortgage market, and into lenders’ vaults.

With the Fed buying and providing abundant capital through its inflationary monetary policy, Fannie and Freddie have begun securitizing mortgages at historically low interest rates. The Fed got what it wished for: mortgage rates crashed by about half, from the already historically low rate of 6.5% in 2008 to a low of just above 3%:

30-Year Fixed Rate Mortgage Average in the United States (MORTGAGE30US), September 2008 to Present

The Fed’s total distortion of mortgage lending: mortgage rates fall from historically low rate of 6.5% to near 3% in four years

The Fed was not careful what it wished for: it has made home mortgage lending an unsustainable business. Net Interest Margins, the money banks make from interest earned on lending, have crashed as the Fed’s policies have taken effect. Most importantly, small banks have seen their NIMs draw closer to their large bank peers. Small banks tend to be portfolio lenders, and hold their loans for interest income more often than their large bank peers. Larger banks operate with lower NIMs, because they sell many of their loans, and so are less sensitive to downward rate pressure:


Net interest margin for banks with < $1 billion in assets (blue), and for banks with > $15 billion in assets (red), 1984 – Present.

The Fed’s policy is helping big banks by doing disservice to small institutions. Small banks are struggling to compete in a low-rate environment that rewards a Wal-Mart-esque approach to loan volume. These institutions are unusually vulnerable to economic shocks: the inevitable uptick in inflation, deposit rates, or credit defaults will plunge hundreds, possibly thousands, of them into failure. If this narrative sounds familiar, it should be: the Savings and Loan crisis played out exactly the same way following the monetary expansion of the 1970s. Taxpayers spent $120 billion to resolve failing thrift institutions as the industry-funded Federal Savings and Loan Insurance Corporation (FSLIC) collapsed.

Small banks have been dying, and big banks growing, since the beginning of the Fed. It is tempting to blame a slight uptick in capital requirements, and other fringe factors, for the decline of small banks. If we fool ourselves into believing that bigger banks are safer banks, we can ignore one more sign of the unsustainable nature of the Fed’s policy. As Thomas Jefferson wrote:

Bank-paper must be suppressed, and the circulating medium must be restored to the nation to whom it belongs.


About Matt Murphy

I'm a software engineer with a certain company you've probably heard of. In my free time, I'm an advocate for individual liberty and free markets.
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