The Shrinking U.S. Banking Sector: On Balance, Who Benefits?

Though the U.S. banking sector was in recovery mode in 2010, it still managed to reach some highs and lows. There were 157 bank failures in the country last year, the most since 1992, according to the Federal Deposit Insurance Corporation . And the number of new bank charters was at a historic low -- 11, compared with 181 three years earlier.

With so many banks leaving the sector and so few entering it, a long-anticipated consolidation process is now under way. The U.S. is expected to end up with no less than 6,529 commercial banks and 1,128 savings institutions by the end of this year. That is a 4.4% decline from the previous year, and it leaves the country with nearly half as many institutions as it had 20 years ago, according to the FDIC. What does this consolidation mean for the banking sector's next 20 years? Should consumers be concerned about the shrinking number of banks?

Many experts expect consolidation to continue and predict that the trend will leave the banking system better off in the long run. "We don't really need as many banks as we used to," says Jack Guttentag, a finance emeritus professor at Wharton and former economist at the Federal Reserve Bank of New York. "Banks now have the power to [set up branches] wherever they want to, so what really matters is how many options a customer has in a certain market."

Therein lies the challenge, according to Kenneth H. Thomas, a Wharton lecturer of finance. As he sees it, not all customers will benefit from greater consolidation. A market, such as the one in the U.S., that is "over-banked," with a supply of banking services exceeding demand, "is generally good for consumers and businesses because it results in lower prices -- i.e., lower loan rates [and] loan/deposit fees and higher deposit rates -- and higher output [in terms of] more varied and innovative products," he notes. "Some may argue that 'over-competition' [or over-banking] could drive weaker banks out of business" -- as happened to Washington Mutual, the savings institution that collapsed in 2008 -- "but then someone else comes in and replaces them yet may reduce the number of offices and amount of services."

History lessons
It is no accident that the U.S. has had such a large number of banks. Rather than setting up one, large national bank as other countries do, the U.S. federal government rolled out various laws in 1784 to encourage multiple banks in individual states. In 1863, a new banking act introduced a national charter that encouraged the establishment of more financial institutions even as it taxed banks with state charters. Nearly 70 years later, with the dawn of the Great Depression, the country had more than 30,000 banks. But the stock market collapse took its toll. In 1933 alone, about 4,000 commercial banks and 1,700 savings-and-loans institutions failed.

The next wave of consolidation occurred in 1994 with the arrival of the Riegle-Neal Interstate Banking and Branching Efficiency Act. That made interstate expansion easier, whether it occurred through M&A activity or organically. The number of banks began shrinking annually by about 4.5% before another period of expansion in the late 1990s, according to the FDIC.

With another swing of the pendulum last year, consolidation returned to 1994 levels. But in contrast to previous times, much of the consolidation has been due to failures rather than through M&A. Shuttered banks have ranged from American National Bank of Ohio, a small institution with assets of $70 million that had struggled for years to turn a profit and was under regulatory pressure until it was closed in March, to $25 billion Colonial BancGroup of Alabama, which closed its doors in the summer of 2009, a few days after regulators started an investigation into accounting irregularities. Colonial, the third largest failure in U.S. history, had all its deposits sold to BB&T, turning it into the ninth-biggest U.S. bank by assets, according to Bloomberg. As for M&A, there were 197 deals last year, a 20-year low.

Loretta J. Mester, a Wharton adjunct professor of finance and director of research at the Federal Reserve Bank of Philadelphia, expects consolidation to continue over the next few years. "In the short term, I think consolidation will pick up as weaker banks go through mergers and acquisitions, and stronger banks take time to get their capital shored up" in their pursuit of greater efficiency and economies of scale, she notes.

The little guy
The institutions that will likely be hardest hit by all this activity will be the community banks. Most of these small, locally owned banks have less than $1 billion in assets but account for 92% of all banks and savings institutions, says the FDIC. For many of them, the arrival of the recent Dodd-Frank Wall Street Reform and Consumer Protection Act was a death knell. Tougher controls involving capital, liquidity, and leverage, along with a surge in regulatory red tape, have left such banks struggling, particularly those with less than $500 million of assets. "Many small banks feel that they are being pushed out of existence by new regulations," Thomas states.

Their plight hasn't been lost on the FDIC, which has launched various initiatives to give community banks some relief. A few weeks ago, for example, it released guidelines that lighten requirements for how these banks manage customers whose accounts are consistently overdrawn. The FDIC has also been encouraging entrepreneurs to buy troubled banks. According to Thomas, this trend started two years ago, when new charters were hard to come by. A case in point: BankUnited, a 70-branch Miami Lakes, Fla.-based financial institution, was taken public earlier this year after the FDIC sold it in 2009 to a bevy of private-equity investors led by John Kanas -- the former chief executive of a Long Island regional bank sold a few years ago to Capital One.

Todd A. Gormley, a Wharton finance professor, says community banks play an important role in local economies. They typically have close relationships with individual customers, while, for example, making loan decisions based more on personalized information than the credit scores and other hard data used by large banks. "Smaller firms and local individuals trying to get loans from larger banks could be a subset of the population that is worse off because of consolidation," Gormley suggests.

There is also something to be said for the often underrated efficiency of smaller lenders that rely on personal relationships as a guarantee against loan defaults. In a study published last year, Stephanie Moulton, a professor of public affairs at Ohio State University, found that borrowers with low incomes or bad credit are significantly less likely to default on loans if they borrow from a local bank than if they receive a loan from a distant bank or mortgage company. Personal relationships, she concluded, are an important factor in the reciprocal relationship between lender and borrower, resulting in having both sides offer critical information, such as repayment schedules.

Easy come, easy go
According to Guttentag, consolidation also leaves a handful of banks controlling the majority of certain types of products. Four "mega banks" -- Wells Fargo (NYSE: WFC  ) , Bank of America (NYSE: BAC  ) , JPMorgan Chase (NYSE: JPM  ) , and Citigroup (NYSE: C  ) -- now hold three-fifths of the home mortgage market, which limits consumers' choice of products and their ability to shop around for competitive pricing. "It's a textbook issue of a concentration of power," Guttentag says. "A limited number of firms control the market, and they will engage in implicit collusion."

Thomas, meanwhile, is concerned about the concentration in geographic markets as a result of ongoing consolidation. While there are more than enough banks in the entire country, some cities, states, and regions have just one dominant bank. "There are a few markets in danger of becoming a one-bank or two-bank town," he says. For example, in the Pittsburgh metropolitan area, PNC Bank (NYSE: PNC  ) has 47% of the deposit share, according to the FDIC. The second-largest bank in the area is Citizens Bank of Pennsylvania, which has 8.5% of the deposit share. "We need competition because competition lowers prices," Thomas states.

While there are no limits on deposit shares in certain markets, 1994's Riegle-Neal Act imposes a 10% cap on nationwide deposits for a single bank. That has since been interpreted as a cap on growth that occurs through mergers rather than organically. The Treasury Department is now looking into modifying the cap to include all consolidated liabilities.

But Mester says consumers need not worry. "When there is consolidation, there are not necessarily fewer outlets for banking services," she notes. While the total number of banks may be declining, the number of branches isn't. In addition, no matter where they are, consumers have access to a growing number of Internet banking options. In the past 10 years, the number of bank branches nationwide has increased by 15%, although that expansion has primarily involved banks with $500 million or more in assets. The number of branches dropped slightly for the first time in a decade in 2010.

As for the future, Guttentag predicts that the number of banks will continue to shrink, but he doubts the U.S. will ever look like, say, Canada -- which has just 22 banks. Indeed, if consolidation continues as it has over the past 20 years at the average annual rate of 3.3%, it would take 60 years for the total number to fall below 1,000 banks and nearly 130 years to get below 100.

"Even if the number of banks shrinks from 6,000 to 100, if those 100 are operating in all market segments and if consumers have many options, there is no reason for concern," Guttentag says.

Additional reading from Knowledge@Wharton:

The Fool owns shares of Bank of America, JPMorgan Chase, and Wells Fargo. Through real-money portfolios, the Fool is also short shares of Bank of America. The Motley Fool has a disclosure policy.


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