"Balancing the cost of regulation that is prescriptive with respect to underwriting, loan structure, and operating procedures against the lack of evidence that balance sheet lending by community banks created significant problems, I think an argument can be made that it is appropriate to establish a separate, simpler regulatory structure to cover such lending," Duke said in prepared remarks for a Chicago speech to the Community Bankers Symposium, an event sponsored jointly by the three federal bank regulatory agencies.
Duke said imposing new restrictions on mortgage lenders, including in rules implementing the Dodd-Frank Act, is "an understandable approach" in light of the subprime mortgage crisis. But certain loan features targeted by policymakers—such as balloon interest payments—are traditional in mortgages originated by community banks. Those characteristics may have endangered subprime lenders in the lead-up to the mortgage meltdown, but community banks should not be penalized for others' abuses, she said.
"Community banks have long been a source of loans that, for a variety of reasons, do not fit the parameters of conforming government-sponsored enterprise loans or eligibility for government-guaranteed programs. Community banks typically hold these loans on their own balance sheets," Duke said. "They use higher interest rates to compensate for the lack of liquidity in these loans or to cover higher processing costs because community banks lack economies of scale, and they use balloon payments as a simple way to limit their interest-rate risk.
"To the extent that regulations require additional operational procedures for such loans that are prohibitively expensive, raise the liability associated with making them, or create capital requirements that are out of proportion to the riskiness of the loans, community banks could be closed out of these products altogether."
She discussed data compiled by Fed staffers that, Duke said, "demonstrate that while the community bank share of the mortgage market is not large, it is significant."
According to information collected under the Home Mortgage Disclosure Act, banks with between $500 million and $10 billion of assets are responsible for about 13% of home loan originations, while those under $500 million of assets account for about 5%. Credit unions, meanwhile, make up an additional 7%.
"Thus, taken together, community banks and credit unions accounted for one-quarter of the new origination market in 2011," Duke said. "This is up from a combined market share of nearly 16% in 2004." During that period, the share for nonbanks went down, and originations for large banks were about the same.
She said that the data points to "evidence that the additional capacity provided by smaller lenders is important, especially at the margin, and could contribute to lowering mortgage rates and loosening lending standards."
Despite community banks' importance in the housing market, Duke said, "crafting regulations to address the real problems that occurred in subprime lending without creating punitive burdens on community banks may prove to be quite difficult."
She specifically pointed to the burden for smaller banks of complying with new capital requirements, as well as certain provisions in Dodd-Frank, including new escrow rules for higher-priced mortgages, compensation standards for loan officers and revised appraisal regulations.
"Within the escrow requirements, the Dodd-Frank Act did provide for an exemption for banks in rural or underserved areas, but I think broader exemptions for community banks should be considered," Duke said.
She said inaction by regulators in recognizing the need for more nuance in rules affecting community banks could have serious consequences.
"If the effect of a regulation is to make a traditional banking service so complicated or expensive that significant numbers of community banks believe they can no longer offer that service, it should raise red flags and spur policymakers to reassess whether the potential benefits of the regulation outweigh the potential loss of community banks' participation in that part of the market," Duke said. "Unfortunately, my discussions with community bankers lead me to believe that we might be approaching that point with residential mortgage lending regulation."