The Federal Reserve (Fed) is valiantly battling to contain the worst inflation America has seen in nearly 40 years without sparking a recession. It can only win that fight if community banks and small businesses are healthy. If the Fed isn’t careful as it continues chasing its preferred inflation rate of 2%, there could be unintended consequences for the country’s littlest economic players.
Community banks, both small and mid-sized institutions, are essential to our country’s financial wellbeing because they primarily serve small businesses, which are the backbone of the economy. Small businesses comprise 99.9% of all U.S. businesses in 2022 and 46.4% of the nation’s workforce. Small business and community banks are inextricably linked. One doesn’t succeed without the other. And right now, both are challenged.
The Fed has been aggressively raising interest rates for over a year to tamp down inflation that peaked at 9.1% in June. And the Fed seems to be winning: The inflation rate now stands at 4.9% and is trending down. But this success has come at the cost of a surge in interest rates. The federal funds rate now stands at 5%-5.25%, up from 0.25%-0.50% in March 2022.
The handful of high-profile failures in recent weeks show the pressure rising interest rates put on banks. Those closures had little to do with community banks, which carry more short-maturity, local loans than their bigger counterparts. Many of those larger banks loaded up on Treasuries and mortgage-backed securities, only to see them decline in value due to Fed rate hikes.
But community banks are still feeling the pressure of higher rates. The longer they stay elevated, the more daunting the challenges will be. Here are just few:
- Deposits cost more. New loans and renewals cost more for local businesses, entrepreneurs, and real estate developers. Community banks service most of the nation’s businesses with 150 or fewer employees and provide roughly 60% of small business loans and more than 80% of all farm loans. About half of all community banks are in rural counties with fewer than 50,000 people.
- Rapidly rising wages are challenging small-business borrowers. Workers are hard to find at any wage. The U.S. unemployment rate is 3.4%, the lowest in 54 years. In Nebraska it’s 2.1%, suggesting that nearly everyone who wants a job has one.
- Nationwide, commercial real estate, or CRE, loans worth about $270 billion are maturing in 2023. Over the past few years, CRE ventures have experienced higher vacancy rates resulting in lower operating income because of pandemic-related business failures and the new work-at-home option for many employees. America’s small and medium-sized banks handle two-thirds of all the CRE loans made by banks. These loans typically have maturities no longer than seven to 10 years and represent about 40 to 50% of community bank loans.
In this difficult business environment, our deposits cost significantly more. We have no choice but to charge more for new loans and renewals. Refinancings are likely to be 50% to 100% more expensive, while the borrowers’ operating profits have declined. This is a tough situation for everyone.
With the fear of losing deposits exceeding the Federal Deposit Insurance Corp.’s $250,000 ceiling, some bigger banks will be cautious in renewing loans to accommodate these stressed situations.
This is where the mid-sized and community banks have an advantage and why we are important to U.S. economic growth and stability. We are integral parts of our communities. Often owned by local residents, community banks usually have closer ties to their borrowers and depositors. We shop at their businesses and buy their products. We keep the money local. The borrower and banker realize their community depends upon their joint success.
Even before this inflationary episode began, community banks were struggling from an increased regulatory environment, including new accounting requirements known as Current Expected Credit Losses, additional reporting on capital ratios, and concentrated oversight on general accepted banking practices that have disproportionately impacted small banks. From 2000 to 2021, the number of banks nationwide fell from 8,315 to 4,236. From 1985 to 2011, 183 new banks started each year on average, yet only four started annually between 2012 and 2019 as the industry consolidated.
The last thing America needs is another round of consolidation, resulting in even fewer community banks.
The coming months will be a trying time as community bankers and borrowers search for creative solutions to the challenges of a higher interest-rate environment. Many experts expect rates to remain elevated until the Fed achieves its 2% inflation goal, which might not be until 2025.
That’s a long time. The Fed would be wise to remember that small businesses and community banks are the backbone of the nation’s economy, and their success is America’s success. Taming inflation without a recession can only be done with a healthy community banking system.