As the number of financial institutions continues to decline in the U.S., bank regulatory framework should be more supportive of startup banks, Federal Reserve Governor Michelle Bowman said in a speech at the Wharton Financial Regulation Conference on Friday.
“[P]reserving and enhancing the number of banks should be a regulatory and legislative imperative,” Bowman said, adding that includes encouraging the formation of de novos.
Bowman pointed to the performance of the nation’s smallest institutions during times of stress, such as the 2008 financial crisis and the pandemic, arguing smaller institutions often outperform their peers in times of crisis.
“[D]uring times of economic and financial stress, the smallest institutions have performed extremely well,” Bowman said, citing small banks’ involvement in the Paycheck Protection Program as an example.
The number of FDIC-insured banks declined by nearly half from 2002 to 2022, from 9,354 to 4,708, according to FDIC data.
Bowman said the reduction appears to have largely been driven by consolidation in the banking industry.
“While there has been a slight uptick in de novo formation over the past few years, compared to the years immediately following the 2008 financial crisis, de novo activity has been significantly outpaced by consolidation,” she said.
Despite the decline, Bowman said several trends, such as the ongoing demand for "charter strip" acquisitions, the growth of non-bank financial entities and the rising demand for banking-as-a-service (BaaS) partnerships, suggest there is an “unmet demand” for de novo bank charters.
Nonbank entities like LendingClub and SoFi have taken the “charter strip” approach by acquiring small community banks in the past several years — moves that have granted the firms access to their own bank charters.
The trend, however, could have an adverse effect on local banking markets, Bowman said.
The target institutions for charter strips are often small banks that provide services in small towns or rural communities, she said.
“Even when these legacy bank businesses continue to operate as an add-on to the new charter-strip business model, the institution as a whole tends to become riskier, jeopardizing the long-term viability of the legacy banking business and its ability to continue providing services to the local community,” she said.
The fact that such transactions occur could also signal dysfunction in the process of de novo chartering, Bowman said.
The demand for charter strips suggests there may be a disparity attributable to the difference in expectations and regulatory burden between acquiring a bank and launching a startup bank, she added.
Bowman, however, said she is not suggesting regulators make bank mergers and acquisitions more restrictive.
“[T]hese, too, are part of a healthy banking system,” she said. “Instead, I would suggest that the regulatory framework should at least be more accommodative toward the de novo process.”
Bowman said policymakers need to consider whether the tight framework of requirements associated with de novo banks is too burdensome, and whether alternatives may be more efficient.
Regulators should consider lowering up-front capitalization requirements of de novo institutions, Bowman said, adding a phased approach that takes into account the early performance of a startup bank could provide similar risk protection with a lower capital burden.
While banking agencies have made some progress by clarifying regulatory expectations and providing more transparency into the application process, Bowman said regulators “need to ask if these steps are sufficient, and whether they can be improved.”
Bowman pointed to the joint bank formation initiative launched by the United Kingdom's Prudential Regulatory Authority and Financial Conduct Authority as a “model for greater transparency and coordination.”
The U.K.’s New Bank Start-up Unit focuses on the broader timeline of de novo formation, rather than an isolated event such as filing an application, she said.
“The process of creating a de novo bank starts before an application is filed, and is a multiyear process, ideally ending after a brief period of early operations with the de novo transitioning into a mature, viable banking franchise,” she said.
The U.K.’s de novo framework also emphasizes the need for startup institutions to contemplate and prepare for recovery, resolvability and a solvent wind-down of operations, Bowman said.
“De novo banks often experience rapid growth, poor initial profitability, and loan quality issues that take time to emerge as the bank's portfolio matures. These factors can make de novo banks riskier than established banking franchises," she said. "The solution to potential weaknesses in de novo banks need not focus exclusively on increasing regulatory and supervisory requirements, particularly if there are lower-cost alternatives like improved transparency, and better preparation for resolvability and solvent wind-down.”
