Community bankers are well aware of the rising costs of supervision and regulation. These higher costs are likely to reduce earnings for some small banks and, it follows, make some owners more inclined to sell.

However, recent analysis by the Federal Reserve Bank of Minneapolis reveals that the rate of consolidation among community banks has not increased recently. Rather, consolidation rates so far are following historical patterns. This is true even though the cost of increased supervision and regulation is hitting the smallest banks particularly hard.

Identifying the rough costs of increased supervision and regulation is exceptionally difficult. Figuring out how many fewer banks would have consolidated absent that increase in costs with any precision is impossible. So how can we try to put numbers on either development?

To figure out the potential costs of increased regulation and supervision, our study assumes that all these costs show up as more staff. Increased hiring means lower earnings. Of course, banks respond to more costly regulation and supervision in many ways. But possible responses will seem to either reduce revenue or increase costs, resulting in lower earnings. That is the focus of our analysis. We also provide a regulatory cost calculator so that others can make these same calculations using assumptions they find most reasonable.

Using assumptions for the amount of  additional hiring caused by more intense supervision and regulation and the cost of the additional staff, our study finds that the smallest banks (those with assets below $50 million) would face almost twice the hit to earnings as other banks, even those with assets between $50 million and $100 million. The reduction in earnings would push roughly 15% of the smallest banks into unprofitability.

Given these effects, one might assume that small bank owners will try to sell, believing they cannot compete effectively. Put another way, the rate of community bank consolidation in an era of increasing supervisory and regulatory costs should be higher than the consolidation rate in the past.

But so far the rate of community bank consolidation is consistent with long-term trends. Our study initially made baseline estimates using data as of mid-2013 of the number of community banks that would be in existence as of mid-2014.  We are now updating on a quarterly basis estimates of the amount of community bank consolidation that will occur over the next 12 months so that we can track consolidation over time.   

We make these estimatesusing a variety of models that, to over-simplify, assume the type of consolidation we have seen in the past will continue into the future. If these models based on historical patterns fail to estimate future consolidation, we have at least one sign that something about current consolidation is different than what we witnessed in the past.  In particular, if the rate of consolidation is higher than expected, one reasonable cause for the pick-up could be higher-cost supervision and regulation.

By way of one example, our most simple baseline estimates as of June 2013 forecasted a national decline of 325 community banks — from 6,534 to 6,209 — by June 2014. The actual decline in the last two quarters of 2013 was 114 to 6,420, less than our predicted value. That fall translates into an annual rate of decline of 3.5%, which is right around the rates of decline for similar periods in the prior two years and a bit above the roughly 3% annual rate of decline characterizing the last 20 years.

Community banks provide unique services that other financial institutions may be unable to provide in their absence. In particular, community banks make a disproportionate share of loans to smaller firms, who may face relatively high costs moving to another lender. Continued research on the cost of regulation and supervision, and its effects on the number of community banks, is necessary to quantify those costs and the potential effect on bank numbers.

Our work to date suggests that while the smallest banks may be particularly vulnerable to higher regulatory costs, these costs have not shown up as higher-than-expected consolidation among community banks just yet. We will continue to monitor rates of consolidation to identify an increase beyond what would occur based on historical patterns.

Ron J. Feldman is executive vice president and senior policy advisor at the Federal Reserve Bank of Minneapolis. He is the senior officer for Supervision, Regulation and Credit, where he oversees the consumer and safety and soundness supervision of roughly 100 state member banks and about 500 bank holding companies.

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