The role of de novo banks in community banking

In 2005, the Federal Deposit Insurance Corporation (FDIC) received a high of 299 application for de novo – or new – banks, and 237 of those were approved. In fact, from 2000 to 2008, 1,042 new community banks were chartered. But after the recession, de novo activity came to a screeching halt. Compared to the average of 154 annual approvals leading up to the financial crisis, there have only been seven de novo banks approved by Federal Deposit Insurance Corporation following the crisis.

The number of community banks has been steadily decreasing. The decline in the volume of small to midsize banks is largely attributed to mergers, which have vastly outpaced failures, even at the peak of bank failures in 2010. As banks have consolidated, many communities have found themselves without a local community bank.

The sharp decline seems to have been acknowledged by the FDIC, and the organization has recently shown signs of welcoming de novo activity. Recently, the FDIC has taken several steps to reduce the obstacles applicants face when attempting to open a bank, including reducing the seven-year business plan required for submittal down to three years.  A task force created by the American Bankers Association (ABA) was assembled with the intention of working with the FDIC to help identify key obstacles facing applicants and recommend solutions.

Barriers to opening a new bank

There are a host of reasons that de novo activity has declined in recent years. After the financial crisis, the FDIC faced heavy criticism for the large number of de novo banks they had approved leading up to the crisis, during which de novo banks had a failure rate of more than twice that of smaller, established community banks. Consequently, the FDIC put stricter regulations in place and became much more selective in its approval of de novo applications.

In addition to regulatory restrictions, there are also a significant number of economic and environmental factors that affect the potential for forming a de novo bank. Since the financial crisis, interest rates have been historically low in comparison to pre-crisis rates. Lower interest rates have ramped up competition and have made it increasingly difficult for smaller banks to grow profits. These smaller banks have to find new ways to level the playing field with their big bank counterparts. Because of this, de novo bank formation is greatly reduced during periods of low interest rates.

Cyclicality is another reason commonly cited for suppressing de novo formation. De novo activity oftentimes ebbs and flows with the economic patterns of growth and recession. Similar to the way de novo formation halted with low interest rates following the crisis, the subsequent recession also attributed to sluggish de novo activity. Traditionally, de novo activity decreases during periods of recession. Notable surges in de novo activity, on the other hand, have occurred during economic upswings, such as the mid-1990s after the banking crisis in the 1980s. Like any startup, de novo banks undertake a considerable amount of risk. Economic shocks greatly increase a de novo’s vulnerability, worrying investors and the FDIC alike.

How de novo banks affect community banking

Community banks play an integral role in the U.S. economy, and they’re a key ally for the agricultural industry, small businesses and residential mortgage borrowers. According to the FDIC, community banks are responsible for approximately 40-50 percent of small business loans nationwide.

“As a trade association and an industry, one of the reasons we like de novo banks is that it brings new energy into the industry,” Wayne Abernathy, ABA’s executive VP of financial institutions policy and regulatory affairs, told American Banker. “It brings new people, new ideas – and just a sense of being part of an industry that’s going somewhere.”

De novo banks help preserve the vitality of the community banking sector, fill important gaps in the local banking markets and provide personal credit services that other institutions may overlook. There has been an uptick in applications for de novo banks, thanks to catalysts like a friendlier regulatory environment and a stronger economy, and the FDIC has taken note. “The FDIC has seen more interest in new bank formation and stands ready to promptly and judiciously evaluate all new applications,” an FDIC spokesman told American Banker. Three new banks have opened so far this year, and 15 other groups have submitted applications. WIth a more welcoming economic environment for de novo banks, coupled with greater regulatory support, it will be interesting to see if de novo banks will rise.