The data that banks report to regulators have characteristics that make determining how community banks' small business lending changed since 2010 difficult. However, GAO's analysis found that the regulatory environment likely had a generally modest effect on various aspects of community banks and their small business lending.

Regulators data on small business lending. The data community banks report to regulators do not accurately capture lending to small businesses because the data exclude some loans to small businesses. Specifically, the definition of small business loans used for banks' reporting excludes loans greater than $1 million and has not been adjusted for inflation since 1992. In addition, the data capture loans by their size rather than the size of the borrowing entity, and therefore could include small loans to large businesses. These limitations hamper regulators' and policymakers' ability to assess actual changes in banks' small business lending, including any effect of regulation.

Amount of lending . GAO's analysis used alternative measures of small business lending and found that community banks' lending likely declined following the financial crisis but then increased from 2013 through 2017. After adjusting regulators' data to account for community bank mergers and other exits, remaining banks' small business lending increased by 5 percent from 2013 through 2017, and total business lending by all community banks grew to exceed 2010 levels. GAO's econometric models also found that community banks' small business lending since 2010 can be explained largely by macroeconomic, local market, and bank characteristics, and that the potential effect of regulatory changes was likely modest.

Lending processes. Based on our nationally representative survey of community banks, GAO estimates that most community banks made changes to their small business lending processes since 2010. Most banks cited the regulatory environment as the primary reason for these changes, which included seeking more documentation from borrowers and taking longer to make loans. Representatives of entities that assist small businesses were mixed on whether these changes affected small businesses’ ability to obtain loans.

Number of community banks. From 2010 through 2017, the population of community banks decreased by about 24 percent, largely due to mergers among community banks and a decline in the rate of new bank formations. However, GAO's econometric model found that macroeconomic, local market, and bank characteristics explained the majority of these trends, but changes in the regulatory environment and other factors may have also played a small role.

Community bank financial performance. Although many institutions reported increasing or reallocating staff and other resources to assist with regulatory compliance since 2010, GAO's analysis suggests that the effect of these changes on profitability and customer service were likely modest.

As regulatory changes do not occur in isolation and their cumulative effect cannot be easily quantified, these results should be interpreted with caution.

Community banks—generally small and locally focused institutions—are important sources of credit to small businesses. Since the 2007–2009 financial crisis, regulators have made significant changes to the regulatory environment. While intended to increase institution soundness and better protect consumers, regulations and supervision can also have effects that Congress or regulators may not have intended. In particular, questions arose as to whether regulatory changes reduced community banks’ ability to make small business loans.

GAO was asked to assess the effect of regulatory changes since 2010 on community banks and small business lending. GAO examined the data regulators use to measure small business lending, as well as the extent of any regulatory effects on the amount of community banks’ small business lending and their lending processes, changes in bank populations, and financial performance. GAO analyzed community bank lending and financial data from 2001 through 2017, built econometric models using these and other data, and surveyed a nationally representative sample of over 450 community banks. GAO also interviewed staff from community banks (selected to ensure a range of sizes and geographic regions), small business advisers, banking and consumer advocacy groups, and financial regulators.

GAO makes three recommendations to banking regulators to reevaluate and modify, as needed, the data they collect to measure small business lending. They agreed to the recommendations.

We are making a total of three recommendations, one each to the Federal Reserve, FDIC, and OCC.

August 6, 2018

Dear Mr. Chairman:

Financial regulators have implemented many new regulations in the aftermath of the 2007–2009 financial crisis. The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) of 2010 included numerous reforms to strengthen practices and oversight of financial institutions.[1] Although community banks and credit unions were exempt from several provisions of this act, they have had to respond to additional regulatory requirements as a result of it and other regulatory efforts. These institutions have historically played an important role in serving their local customers, including providing credit to small businesses. Because small businesses are important to the economic well-being of the United States, questions have been raised about the effect of regulations on their ability to access credit from smaller depository institutions. According to Census Bureau data, businesses with less than 500 employees accounted for about 48 percent of U.S. total employment in 2015. A 2017 Small Business Administration (SBA) report indicated that small businesses annually contribute almost 40 percent of the U.S. private nonfarm output, but noted that these businesses typically faced challenges accessing credit, a key element of small business survival and growth.[2]

You asked us to examine the effects of changes in the regulatory environment on community banks and credit unions and their ability to meet the needs of small businesses. Changes in the regulatory environment encompass changes to specific laws and regulations as well as changes in how existing requirements are implemented and enforced. This report examines, for the period 2010 through 2017, the effect of the regulatory environment on community banks and credit unions, including (1) the data regulators use to measure the volume of small business lending and how and why small business lending volumes changed, (2) how and why small business lending processes changed among these institutions, and (3) how and why the number of institutions and their financial performance changed, as well as (4) actions regulators took to identify and mitigate the effects of changes in the regulatory environment on these institutions and their small business customers.[3] In response to your request, we also provided you with a report in February 2018 that addressed which regulations institutions viewed as most burdensome and what actions financial regulators had been taking to reduce this burden.[4]

To identify how and why community banks' and credit unions' small business lending, number of institutions, and financial performance changed, we took the following steps:

• Analyzing available data. We analyzed bank and credit union regulatory data on the level of small business lending; mergers, failures, and new institution formation; and the market shares, resource costs, profitability, and operational efficiency of these institutions from 2001 through 2017.[5] Because of limitations with regulators' data, we also used two alternative measures—(1) business loans of $1 million or less made by survivor community banks (that is, community banks that did not become or merge with a large bank, voluntarily exit the market, or fail during the period we examined) and (2) community banks' total business loans—as proxy measures of small business lending. We believe that these measures, identified through our internal analyses and our conversations with bank regulators, were suitable as alternative measures of small business lending.
• Econometric modeling. We developed econometric models to better understand how many of the changes in community bank trends (such as small business lending, mergers, and new bank formations) could potentially be attributable to changes in the regulatory environment since 2010. Because measuring the cumulative effect of changes in the regulatory environment is difficult, we used a two-stage approach that did not involve estimating regulatory effects directly. First, we developed models that used data on macroeconomic, local market, and bank characteristics (factors represented by variables we could measure) from 2003 through 2009 to forecast community bank trends from 2010 through 2016. Second, by comparing the observed trends that actually occurred during the period to the trends forecasted by the models, we drew conclusions about the influence of "other factors," which could include the influence of changes in the regulatory environment since 2010, changes in demand for small business loans, technological advancements, and incentives for banks to achieve economies of scale, among other things. However, because we cannot distinguish the components of the "other factors" category from one another, we cannot know with certainty the effect of changes in the regulatory environment on community bank trends.
• Surveying community banks and credit unions. We surveyed generalizable samples of more than 450 community banks and 450 credit unions (selected to represent urban and rural areas, geographic regions, and a range of size categories) to identify why they may have made changes to their operations from January 2010 through August 2017.[6]
• Interviewing key stakeholders. We interviewed 18 banks and credit unions, selected to represent a range of asset sizes and geographic regions; consumer groups and financial services advocacy groups chosen because of their familiarity with community banks and credit unions and changes in the regulatory environment; and entities that advocate on business issues or that provide advice to businesses on lending issues.

To determine how regulators identified the effects of regulatory changes, we interviewed staff from the Board of Governors of the Federal Reserve System (Federal Reserve), the Bureau of Consumer Financial Protection (BCFP), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), and the Office of the Comptroller of the Currency (OCC).[7] We also analyzed studies by these entities and other researchers and academics on trends in banking and lending. In addition, we interviewed staff from SBA. Appendix I provides more detail on our scope and methodology, and appendix II provides the structure and specifications of the econometric modeling and the data we used as inputs.

We conducted this performance audit from November 2016 to August 2018 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

Community banks are generally smaller banks that provide relationship banking services to local communities and have management and board members who reside in the communities they serve. Regulators and others have observed that community banks tend to differ from larger banks in their relationships with customers. Large banks are more likely to engage in transactional banking, which focuses on highly standardized products that require little human input and are underwritten using statistical information. In contrast, community banks are more likely to engage in what is known as relationship banking, in which banks consider not only data and statistics but also nonquantifiable information acquired primarily by working with the banking customer over time. Using this banking model, community banks may be able to extend credit to customers, such as small business owners, who might not be considered for a loan from a larger bank that engages in transactional banking.

Small business lending is a significant activity by community banks. As of June 2017, community banks had over $292 billion outstanding in business loans with original principal balances under $1 million (which is how small business loans are defined in regulatory reports), which represented about 19 percent of these institutions’ total lending. In that same month, large banks held about $390 billion outstanding in business loans with original principal balances under $1 million, representing 5 percent of their total lending.

Credit unions are nonprofit, member-owned institutions that take deposits and make loans. Unlike banks, credit unions are subject to limits on their membership because members must share a “common bond”—for example, working for the same employer or living in the same community. In addition to providing consumer products to their members, credit unions are also allowed to make loans for business activities subject to certain restrictions. These "member business loans" are defined as a loan, line of credit, or letter of credit that a credit union extends to a borrower for a commercial, industrial, agricultural, or professional purpose.[8]

Regulators Overseeing Community Banks and Credit Unions

The regulator responsible for overseeing a community bank or credit union varies depending on how the institution has been chartered and whether it is federally insured (see table 1). Federal depository institution regulators are responsible for ensuring the safety and soundness of the institutions they oversee, protecting federal deposit insurance funds, promoting stability in financial markets, and enforcing compliance with applicable consumer protection laws. All depository institutions that are covered by federal deposit insurance have a federal prudential regulator that oversees the safety and soundness of the institution and may issue regulations and take enforcement actions against institutions within its jurisdiction.

Other federal agencies also impose regulatory requirements on banks and credit unions. These include rules issued by BCFP, which was created by the Dodd-Frank Act and implements and, where applicable, enforces federal consumer financial laws.[9] BCFP has supervisory and enforcement authority for federal consumer financial laws for insured depository institutions with more than $10 billion in assets and their affiliates. The federal depository institution regulators—FDIC, the Federal Reserve, OCC, and NCUA—examine how federally insured institutions with $10 billion or less in assets comply with consumer protection requirements. Although community banks and credit unions with less than $10 billion in assets would not typically be subject to examinations by BCFP, they are generally required to comply with the rules related to consumer protection issued by this agency.

In addition, the Financial Crimes Enforcement Network (FinCEN) issues regulations that financial institutions, including banks and credit unions, must follow. FinCEN is a component of the Department of the Treasury’s Office of Terrorism and Financial Intelligence, and it supports government agencies by collecting, analyzing, and disseminating financial intelligence information to combat money laundering. It is responsible for administering the Bank Secrecy Act, which, with its implementing regulations, generally requires banks, credit unions, and other financial institutions, among others, to collect and retain various records of customer transactions, verify customers’ identities in certain situations, maintain anti-money laundering programs, and report suspicious and large cash transactions.[10] FinCEN relies on financial regulators and other entities to conduct examinations of U.S. financial institutions across a variety of financial sectors to determine compliance with these regulations.

Impact of the 2007–2009 Financial Crisis

Assessing the effect of changes in the regulatory environment in the period following the 2007–2009 crisis is complicated by the severity of the crisis’s economic impact on the United States. In a January 2013 report, we reviewed academic and other sources and found that the 2007–2009 financial crisis, like past financial crises, was associated with a steep decline in output and the most severe economic downturn since the Great Depression of the 1930s.[11] The U.S. economy entered a recession in December 2007 that lasted until June 2009, with U.S. real gross domestic product falling by nearly 5 percent and not regaining its pre-recession level until the third quarter of 2011. Some studies noted that the impacts of the crisis could persist beyond 2018 or be permanent.

The 2007–2009 crisis was also associated with large declines in employment, household wealth, and other economic indicators that could have affected the rate of new business formations and demand for small business loans. The monthly unemployment rate peaked at around 10 percent in October 2009 and remained above 8 percent for over 3 years, the longest such stretch since the Great Depression. Between 2005 and 2011, households collectively lost about $9.1 trillion (in constant 2011 dollars) in national home equity in part because of the decline in home prices. The Federal Reserve’s Survey of Consumer Finances found that median household net worth fell by $49,100 per family, nearly 39 percent, from 2007 through 2010. Such dramatic declines in net worth, combined with an uncertain economic outlook and reduced job security, can cause consumers to reduce spending, and lower the financial health of businesses and their willingness to seek credit. Reduced consumption, all else being equal, further reduces aggregate demand and real gross domestic product. However, our 2013 report noted that analyzing the peak-to-trough changes in certain measures, such as home prices, can overstate the impacts associated with the crisis, as valuations before the crisis may have been inflated and unsustainable.[12]

Changes to Financial Regulations since 2010

In response to the 2007–2009 financial crisis, Congress passed the Dodd-Frank Act, which became law on July 21, 2010. The act included numerous reforms to strengthen oversight of financial services firms, including consolidating consumer protection responsibilities within BCFP, which the act created. The Dodd-Frank Act also directed or granted authority to federal financial regulatory agencies to issue hundreds of regulations to implement the act’s reforms. Many of the act's provisions target the largest and most complex financial institutions, and regulators have noted that much of the act is not meant to apply to community banks or credit unions.

Although the Dodd-Frank Act exempts small institutions, such as community banks and credit unions, from several of its provisions and authorizes federal regulators to provide small institutions with relief from certain regulations, it also contains provisions that impose additional restrictions and compliance costs on these institutions. As we reported in 2012, federal regulators, state regulatory associations, and industry associations collectively identified provisions within 7 of the act’s 16 titles that they expected to affect community banks and credit unions.[13]

In addition to regulations resulting from the Dodd-Frank Act, other regulations have created potential burdens for community banks. For example, depository institution regulators also revised the capital requirements applicable to banking organizations, including community banks. These requirements were to implement the Basel III framework, a comprehensive set of reforms to strengthen global capital and liquidity standards issued by an international body consisting of representatives of various countries’ central banks and regulators. These new requirements significantly changed the risk-based capital standards for banks and bank holding companies and introduced new leverage and liquidity standards. As we reported in November 2014, officials interviewed from community banks did not anticipate any difficulties in meeting the new U.S. capital requirements but expected to incur additional compliance costs.[14]

Although a number of provisions may ultimately affect lending by smaller institutions, we noted in our 2012 report that officials from federal agencies, state regulatory associations, and industry associations identified only one provision in the Dodd-Frank Act that was directly related to small business lending.[15] This provision was section 1071 of the Dodd-Frank Act, which amended the Equal Credit Opportunity Act to require financial institutions to compile, maintain, and report information concerning credit applications made by women-owned, minority-owned, and small businesses in accordance with regulations issued by BCFP. The purpose of the provision was to facilitate the enforcement of fair lending laws and enable communities, governmental entities, and creditors to identify the business and community development needs and opportunities of women-owned, minority-owned, and small businesses. In May 2017, BCFP issued a request for information to seek public comments to inform its efforts to implement this additional reporting.[16]

However, some Dodd-Frank Act provisions have also likely resulted in reduced costs for community banks. For example, revisions to how deposit insurance premiums are calculated reduced premiums by 33 percent for banks with less than $10 billion in assets between the first and second quarters of 2011. Another change reduced the audit-related costs that some banks were incurring in complying with provisions of the Sarbanes-Oxley Act.

Potential Benefits of Financial Regulation

Financial regulations can also provide significant benefits. For example, a primary objective of banking regulations is to promote the safety and soundness of banks and the banking system.[17] Effective regulation and supervision can safeguard against future financial crises and provide an important source of confidence to the market about the general health and resiliency of the banking sector. Past banking-related crises have demonstrated the need for federal banking regulators to respond proactively to problems developing in the banking system. In February 2018, we reported that staff of federal regulators and consumer groups noted various benefits of regulations related to mortgage activities and requirements to report suspicious banking activities.[18] For example, they said that collecting data on a mortgage applicant’s demographic characteristics (such as an applicant's race, ethnicity, and sex) has helped address discriminatory lending practices and are essential for the enforcement of fair lending laws and regulations.[19] Similarly, regulators have reported that requirements for institutions to report large cash deposits help ensure that the U.S. financial sector is not used to aid illicit activity, including the sale of illegal narcotics, terrorism, and human trafficking.[20]