Who Wants to Start a Bank?

"It has been many years since anyone even talked to us about starting a new bank," says Wayne Whitham Jr., a lawyer in the Richmond office of the law firm Williams Mullen who has worked with banks and financial institutions since the early 1980s.

When it comes to de novos, the last seven years stand out in stark contrast to any time before. (See chart below.) What can explain this trend, and what does it mean for the future of banking?

Keeping Up with Regulations

As in any industry, the decision to start a new bank involves weighing the expected costs and benefits. One of those costs is complying with regulations. While there is no direct measure of the regulatory burden on banks, one possible proxy is the size of banks' quarterly financial report to regulators, known as the Call Report. According to a 2015 Dallas Fed article, Call Reports have grown an average of 10 pages each decade starting in the 1980s. But this pace seems to have accelerated since the financial crisis. From 2007 to 2015, the size of the Call Report jumped from about 50 pages to 84. Moreover, the Dallas Fed notes that the number and complexity of banking laws has grown steadily since 1970.

Longer and more complex regulations require more specialized personnel to interpret and ensure compliance. Thanks to economies of scale, large banks can devote more resources to this task than smaller banks but a smaller share of their workforce.

"In the case of a small community bank, there may have been one person who oversaw risk management and regulatory compliance in the past," says Pat Satterfield, the community bank relationship manager at Williams Mullen. "Now there might be five or six people in that same space." For a community bank with a small number of employees, that burden can be significant.

In a 2013 survey of about 200 small banks by the free-market-oriented Mercatus Center at George Mason University, most banks reported increased compliance costs, and more than a quarter of them said they anticipated hiring additional compliance personnel sometime in the next year. For the smallest institutions, hiring additional personnel dedicated to compliance rather than business can be a serious cost. According to estimates by the Minneapolis Fed, hiring just two additional people for compliance would make one in three banks with less than $50 million in assets unprofitable.

This is especially relevant for new banks, most of which start out (and stay) small. According to the FDIC, more than 90 percent of banks in the United States had less than $10 billion in assets. And between 2000 and 2008, 77 percent of newly chartered banks opened with less than $1 billion in assets.

"Historically in a startup bank, people wore a lot of hats," says Fred Green, president and CEO of the South Carolina Bankers Association and a former director of the Richmond Fed. "To start a bank today, you need dedicated human resources for compliance-related issues, which creates a higher fixed cost."

New banks are already subject to higher capital requirements and more frequent examinations from the FDIC in their first years, adding to their fixed costs. But in 2009, the FDIC increased this window from three to seven years, noting that many of the banks that failed in 2008 and 2009 were less than seven years old. Requiring new banks to hold more capital may make them less prone to failure, but it also raises the barrier for them to get off the ground in the first place. Perhaps recognizing this, the FDIC returned the enhanced supervisory period back to three years in April. Announcing the decision, FDIC Chairman Martin Gruenberg said "the FDIC welcomes applications for deposit insurance."

But not everyone in the banking community has found the process for starting a new bank entirely welcoming. Starting a new bank has never been easy. But organizers of the Bank of Bird-in-Hand reported a longer and more difficult application process than in years past. Other industry veterans also say there has been a shift following the financial crisis. Chip Mahan started his first bank in 1987 and his latest one, Live Oak Bank in Wilmington, N.C., 20 years later. "The two experiences could not have been more different," he says. In the first case, he doesn't even remember talking with the FDIC directly, while in the case of Live Oak, he had two meetings with Sheila Bair (then the head of the FDIC) to present his case.

But regulations are only one piece of the puzzle. "Everyone likes to blame everything on the regulators," says Mahan, "but that just doesn't cut it."

Low Rates, Low Profits

While new regulations can weigh on bank profits, bank organizers may be even more sensitive to changes in interest rates. According to the FDIC, community banks earn as much as 80 percent of their revenue in the form of net interest income, or the spread between the interest earned on loans and the interest paid to depositors. Near-zero interest rates since 2008 have made that spread less than in years past.

This not only puts pressure on existing banks but may also play a role in dissuading new bank formation. In a 2016 Review of Industrial Organization article, Robert Adams and Jacob Gramlich of the Federal Reserve Board of Governors found that new banks have historically held a much higher percentage of federal funds reserve deposits and earn even smaller interest spreads than both large and small incumbent banks. Perhaps in part because of this, the number of new bank charters has closely tracked the federal funds rate going back as far as the 1970s. Using an econometric model to analyze the data, Adams and Gramlich attribute at least 75 percent of the recent decline in new bank formation to nonregulatory factors like low interest rates and the weak economy. In a 2014 article in the Richmond Fed journal Economic Quarterly, however, former Richmond Fed researchers Roisin McCord and Edward S. Prescott noted that net interest income has been similarly low in previous recessions without a complete collapse in new bank entry. This would suggest that low interest rates, too, tell only part of the story.

Still, it is clear that even large, established banks have struggled to profit in the post-recession economy. Bank stocks lagged behind the rest of the market in the first quarter of 2016. In an effort to trim costs, Bank of America has cut more than 70,000 jobs since 2010 and announced another round of cuts in May. In this climate, organizers interested in starting a new bank may have difficulty finding investors who share their enthusiasm.

"In the old days, a lot of de novo banks had a five- or six-year plan: open, grow, and sell," says Green. "Those sales prices were generally very attractive, something like two or more times the book value of the bank. You're not going to see that today. So it's hard to model a compelling reason for someone to invest in a new bank versus publicly traded companies that are already doing well."

Mahan argues that new banks can still succeed, but they need to think outside the box. His bank has rejected the traditional community banking model of taking deposits and making traditional loans. Instead, Live Oak built an online platform for making loans to specific businesses qualified for the U.S. Small Business Administration's 7(a) Loan Program. Live Oak's clients are an eclectic mix of industries, including dentists, veterinarians, and craft breweries. Mahan says his bank earns most of its profits from selling the loans it makes on the secondary market rather than relying on interest income.

"Following the traditional banking model with interest rates at an all-time low is a failed strategy," says Mahan. "You need to think of something a little bit different."

Why Care About Bank Entry?

Is there any reason to worry that there are far fewer new banks? Some have suggested it could matter for segments of the economy that have relied on traditional community banks.

Some economists have long thought that small banks may be better equipped to serve small businesses. Those firms have a difficult time obtaining funding because they typically do not have access to public equity markets and can struggle to signal their creditworthiness to lenders. To overcome this difficulty, small firms may depend on "relationship lending" with local banks. Lenders who build relationships with business owners and entrepreneurs in the community can use that information to supplement more formal means of assessing credit worthiness. In a 2002 article, Allen Berger of the University of South Carolina and Gregory Udell of Indiana University found that small banks are organizationally better equipped to engage in this sort of relationship lending than large banks.