Investing in Smaller Banking

The financial overhaul ratified via the Dodd-Frank bill is not primarily aimed at small to medium-sized banks, according to Federal Reserve Chairman Ben Bernanke, but rather to the larger institutions to which the financial crisis was to blame. Even though smaller banks must incur many costs to comply with some new regulations, investors may consider investing in smaller banking for the long term.

The financial regulation passed in the aftermath of the financial crisis in 2008, and created many new requirements for institutions to follow, as well as a plethora of new committees and agencies to oversee the industry. To end the "too big to fail" problem, banking institutions will be required to retain higher levels of capital, among other stipulations, in order to insure against potential losses.

While this regulation obviously affects institutions such as JPMorgan Chase (NYSE: JPM  ) , Bank of America (NYSE: BAC  ) , and Citigroup (NYSE: C  ) , less attention has been focused on the effects this regulation will have on the smaller institutions -- the ones that would never become too big to fail. Bernanke addressed several concerns at the Independent Community Bankers of America National Convention yesterday and explained that a subcommittee had been created to focus specifically on the smaller institutions to assess and monitor the effects that certain policy proposals would have on these banks.

According to the article, executives from the smaller banks have raised the issue that the regulations have created a costly burden for them as well, an unfair cost due to their lack of contribution to the financial crisis. Bernanke conceded but did point out that most requirements are aimed principally at the biggest banks, and not the smaller ones. Bernanke also said the financial overhaul will serve to level the playing field between larger institutions and the smaller community banks. Bernanke explains that due to the competitive distortions existing between "too big to fail" institutions and smaller community banks, the latter had less opportunity to compete. By imposing strict rules on the larger institutions, it creates more opportunity as consolidation and concentration by larger firms becomes more costly and inconvenient for them to do so.

While JP Morgan and Citigroup are household names, they do little to affect Main Street. The Office of Advocacy provided data which suggests that 99.7% of all businesses are small businesses. Small businesses supply the majority of new job creation, and small banks are a vital source of loans for these firms. JP Morgan is not likely to be lending to your corner barbershop. Americans, and their businesses, are affected much more by the existence and prosperity of smaller banking institutions.

Noble as the financial regulation may be, it may have far-reaching unintended consequences. Logical reasoning would lead to the conclusion that higher costs for the smaller banking institutions lead to less funds available for loans to small businesses. Indeed, banks with assets between $250 million and $1 billion showed a slight decline in business lending. It can be argued that this subsequently leads to less small business growth, and subsequently less job creation. As the frail economy continues to struggle with high unemployment, the added variable of the financial overhaul and its effect on small banks may in fact, be impeding the recovery in respect to more stable levels of employment.

Although financial overhaul may have negative side effects for the broader economy, investors may still wish to use this as a buying opportunity. It is more difficult to invest in smaller banking institutions than it is to invest in the giants listed above, but there are options. The SPDR KBW Regional Banking ETF (NYSE: KRE  ) tracks the KBW Regional Banking Index, and has a -5.7% 3 year total return, but has returned over 10% in the past year. Although small banks complained about the costs of complying with new regulations, it may be a great entry point for investors to take a stake in smaller banking. Rebound from the financial crisis created the opportunity for large banks to yield high returns, but it is unlikely that similar returns will persist into the future. Smaller banking may become more important in the future, and investing in this ETF, or similar ones, may present an excellent long-term investment.

Disclosures: long C

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