In 2011, 92 FDIC-insured banks failed. Eighty-five of the failed institutions had less than $1 billion in assets — the technical definition of community bank. Of 157 bank failures in 2010, all but 23 were community banks. Without a doubt, the last couple of years have been unkind to these small banks, where loan officers know your name, know the area, and have a vested interest in seeing it prosper.

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Unlike a megabank with headquarters in Wilmington, DE, or wherever, a small community bank will benefit directly from investing in local economic development — the larger and more prosperous the community, the larger and more prosperous the bank. And this is what ultimately led to so many community banks’ downfall. But that’s not the story you hear all the time.

A Popular Scapegoat

Frequently commentators will bemoan the negative effects the Dodd-Frank Act has had on community banks. Newt Gingrich claimed that law, which is only half-enacted at this point, is killing small banks with over-regulation. American Banker ran a long story on the candidate, praising Gingrich during the summer doldrums of his campaign, calling him “the community banking candidate.”

More recently, the same publication ran an op-ed about a fictional banker named Ed who was forced to shut his community bank down due to compliance costs associated with new regulations, and as a result, turned his town into a slum. (“In the years after [the bank’s closing], the community died more than a little.”) And while the op-ed might be a touch melodramatic, there’s a point to it: a community bank’s closing can potentially stymie local growth and access to capital, which is why seeing over 200 community banks fail in two years is troubling.

In order to deal with the problem — if it hasn’t already been dealt with — we need to be more honest about the cause of community bank failures. In order to offer some insight, we spoke with Chris Cole of Independent Community Bankers of America.

Dodd-Frank to Blame?

Dodd-Frank, Cole explained, is not what has been hurting community banks. The bill hasn’t even fully gone into effect yet, he pointed out, and the only part of it that has had any negative effect on community banks is the Durbin Amendment. Despite small banks’ exemption from the debit interchange limits, Cole explained that the market is slowly closing the gap between regulated and exempt debit swipe fees, thereby cutting into community bank interchange revenues even though they are technically exempt.

Aside from that, Cole pointed to three concurrent trends that have worked together to harm community banks: overconcentration in commercial and residential real estate lending, limited access to capital, and tougher examinations by regulators. Taken together, these form a lethal combination for small lenders.

Because these banks were so deep in real estate construction lending, they ended up with plenty of useless real estate on their hands once the market collapsed. Once a bank has too much REO on its books, federal regulators will tell them to raise capital, and to write down the loans, said Cole, and examiners pick seemingly arbitrary numbers when deciding how much capital community banks are forced to raise (a big problem for community banks, said Cole). Once the head of the bank turns to his board for more capital, he or she will probably find them unwilling or unable to do so. So they go into receivership with the FDIC, and are subsumed by another larger bank.

Federal regulation rears its head but once in this scenario, and only through the agencies assigned to regulate banks — i.e., not the White House or Congress. Blame falls on neither Obama nor the Congress that passed Dodd-Frank. The agencies are the only ones flexing too much regulatory muscle, and only in response to a calamitous decline in real estate values.

“In my theory it’s their own reaction to the crisis,” said Cole of the FDIC and other regulators. They were caught not doing their job effectively, and they don’t intend to let it happen again. This can-do attitude sometimes comes at the expense of banks that could potentially rebound from their burdensome real estate holdings, but aren’t given the chance.

Compliance costs associated with Dodd-Frank simply don’t fit into this picture; real estate development lending and the scarcity of capital do. Keep this in mind next time you see someone using the demise of more than 200 community banks to score political points.

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