A lesson in history: What role competition plays in banking and why there are so many banks in America

There are 4,100 banks in the US. These numbers outpace other major economies like Canada (81), Japan (112) and the UK (311). Why does America have so many banks? And does it have anything to do with the recent bank failures? 

Banking in America is a mix of community and regional banks and Too Big To Fail (TBTF) banks like JPMorgan Chase. Even though TBTF banks are steadily becoming even larger, smaller banks – those with less $250 billion in assets -- shoulder more than 80% of all commercial real estate loans. 

History has its eyes on you

This collage of small and TBTF banks is apparently as old as America itself. The story goes that Alexander Hamilton, the first Treasury Secretary, wanted a centralized banking system with one dominant national bank. But uneasy with the influence these large banks would have over state-based banks, Thomas Jefferson, the first U.S. Secretary of State disagreed. Washington eventually sided with Hamilton, resulting in the country’s first two national banks in 1791 and 1816. Jefferson argued that the constitution had given Congress no authority to create a national bank. When the national bank’s charter expired in 1836, Hamilton had died and his party was no longer in power, and the number of state banks had greatly increased. 

President Andrew Jackson’s opposition to national banks sealed the fate of Hamilton’s national bank dream in what is often dubbed as the Bank Wars. After the dust had settled on Hamilton and Jefferson’s debate, President Lincoln resuscitated centralized national banks during the American Civil War, sowing the seeds of the patchwork banking system that is in business today. 

The number of banks grew in tandem with America’s own growth, peaking at 30,000 in 1921. The Great Depression made a significant dent in this growth and by the end of 1933, the bank population had more than halved. In 1933, the FDIC was created but the number of banks continued to decline until 1963. In the period that followed until 1984, many new banks were granted charters with the net gain in banks reaching 1.8%. However, since 1984, the number of banks has been steadily declining. 

When Congress allowed larger banks to acquire smaller banks across state lines in the late 20th century, it paved the way for banks to become truly Too Big To Fail.

The financial crisis of 2007 and 2008

The last financial crisis had repercussions not only for America but the entire world. When Lehman Brothers collapsed, the Emergency Economic Stabilization Act (EESA) authorized the government to buy troubled assets to stabilize the financial system. This financial crisis and the regulations that followed were the second step in cementing the position of TBTF banks. 

Similarly the Dodd-Frank Act was created to prevent future bailouts; it included new regulations concerning capital requirements, proprietary trading, and consumer lending. It also imposed higher requirements for banks that were deemed systemically important financial institutions (SIFIs). 

But there are critics of this system, who argue that this setup burdens smaller banks a lot more than larger ones. These critics argued in 2012 that “Dodd-Frank will likely have the unintended effect of encouraging consolidation in banking and other financial sectors. Dodd-Frank will harm competition in the financial services industry because its regulations fall hardest on small banks and credit unions which makes it harder for them to compete with their larger counterparts.” 

More than a decade later, these critiques have started to ring true. For example, in the case of First Republic’s takeover by JPMorgan Chase, the TBTF bank was able to afford a “better value package”, due to its size. Since FDIC has a duty to choose the “least-cost” solution, JPMC won the bid. Some members of the congress  argued that this kind of self-fulfilling prophecy creates a bank that is not only too big to fail but also too complex to handle. 

Living in the moment: The current regional bank crisis

On the other hand, the current bank crisis is, for now, regional. Here, critics of Dodd-Frank from 2012 argue that the Act could have unintended consequences for smaller banks. They state that the cost of complying with regulations has historically been 2.5 times higher for smaller banks, which may push them out of business or into mergers with bigger banks. Sound familiar?

While the number of recent bank failures is uncharacteristically high, the reason why it is worrying is rooted in the Hamilton-Jefferson disagreement about what role competition plays in the banking industry. For example, in 2018, the FDIC chairman issued a statement saying that “one of my key priorities is to encourage new bank formation.” New banks are a great source of new capital, as well as ways to serve customers, particularly in underserved local communities. 

Although 4,100 seems like a lot of banks, data shows that the issuance of new bank charters has generally slowed down. In 2022, only 14 new charters were issued by the FDIC.

Even though Jefferson and Hamilton are long gone, the debate about what role competition plays in the banking industry is still very much alive in the zeitgeist. With every bank failure, the role of TBTF banks and their asset size is thrown into sharp relief. If America wants to preserve its emphasis on healthy competition, merely stopping banks from failing might not be enough. Letting new banks emerge and grow might be the answer to the problem of TBTF/too complex to handle the quandary that the likes JP Morgan pose.