The Impact of the Financial Crisis on Community Banks: A Conference Summary
Kawa, Mark H., VanBever, Steven, Chicago Fed Letter
The fifth annual Community Bankers Symposium, co-sponsored by the Federal Reserve Bank of Chicago and the Midwest Region of the Federal Deposit Insurance Corporation, was held at the Chicago Fed on November 6, 2009. This article summarizes the key presentations and discussions at the conference.
Representing the Federal Reserve System at the Community Bankers Symposium were Elizabeth A. Duke, Governor, Board of Governors of the Federal Reserve System; and Charles L. Evans, president and CEO, Carl R. Tannenbaum, vice president, and Mark H. Kawa, vice president - all from the Federal Reserve Bank of Chicago. Speakers from the Federal Deposit Insurance Corporation (FDIC) were Richard Brown, chief economist, and M. Anthony Lowe, regional director of the Midwest Region. Mark Zandi, chief economist and co-founder, Moody's Economy.com, also addressed the gathering. Nearly 300 individuals, primarily representatives from community banks1 in the Seventh Federal Reserve District,2 attended the symposium.
This year's theme for the symposium was "Are We There Yet?" Symposium participants discussed whether the overall economy had yet reached the point of recovery from the financial crisis. They also explored the risks facing community banks in the current environment and helped identify key supervisory and policy issues.
On the surface, the current financial crisis appears to be mainly a story about very large banks. Many of these banks undertook excessive risks in the environment of strong economic growth that existed until around mid-2007. When economic conditions changed dramatically, banks began facing severe liquidity strains and a loss of market confidence. The financial system was stabilized only through an unprecedented range of new federal government and Federal Reserve programs to support firms and consumers and to restore the flow of capital in the economy.
Less obvious is the connection between community banks and risks to the financial system. The failure of a single community bank does not generally have a significant impact on the financial system as a whole. However, because community banks individually lack the geographical and product diversification available to larger banks, they can become exposed collectively to regional and sectoral economic downturns - such as a downturn in residential and commercial real estate (CRE) markets.3 These downturns can then cause a large number of community banks to weaken or fail, which in turn can lead to significant credit constraints on firms (particularly small businesses) that rely heavily on these banks for working capital. This can then adversely affect local communities and the broader economy. It is this dynamic that we have been seeing in the current crisis.
Community banks and the financial crisis
Tannenbaum proposed that, while the extent and magnitude of the recent financial crisis were unexpected, the groundwork for such an event was formed over the past generation by evolutions in financial products, business models, and government regulations. These evolutions affected banks of all sizes.
Prior to the 1970s, commercial banking was heavily regulated, quite stable, and profitable, but not especially innovative or dynamic. Then, beginning in the 1970s, the traditional bank business model came under increasing pressure from macroeconomic volatility, new technologies, and business innovations, such as securitization4 and the originate-todistribute model.5 It also appears that in some cases incentives were misaligned, said Tannenbaum. The existence of a "shadow banking system"6 created incentives to shift risks to unregulated or less regulated firms. Finally, bankers, investors, and rating agencies should have adopted a more critical attitude toward new financial products; they should have also been more skeptical about the mathematical models used to measure and manage risk.
According to Tannenbaum, these industry-wide developments "trickled down" to community banks in various ways. …