A New Proposal to Expand Banking Services in Rural America

By | December 15, 2018

There are now two Americas. A growing, dynamic, and prosperous urban America (including suburbs) that votes almost exclusively Democratic, and a shrinking, poor, rural America that votes Republican. This divide carries significant consequences, from increased polarization to the opioid epidemic, and defies traditional economic logic. Unless something is done soon to turn around the economic fortunes of rural America, the political and cultural cleavage between rural and urban areas will become complete, and Americans will consider their fellow citizens in other parts of the country as foreign as, well, foreigners.

For most of the 20th century, wage differences and economic activity between rural and urban areas shrank as workers moved to higher wage regions while businesses moved to low-wage locations – thus contributing to economic convergence. This relationship began to break down in the 1980’s, as the forces of globalization and technological change decimated the manufacturing sector in America’s heartland and led to a migration of high-skilled workers to urban areas that became “clusters” of economic activity. These clusters attracted even more high-skilled workers wanting to live and work near like-ability peers, as well as businesses that were drawn by a plentiful talent pool. The result was a self-perpetuating cycle of urban areas becoming wealthier, while rural communities slid further into despair. Rural America’s status was cemented last year, when the Wall Street Journal ran a front-page article titled “Rural America Is the New ‘Inner City’”. The article ranks rural areas as the worst among four major U.S. population groupings (the others being big cities, suburbs and medium or small metro areas) in terms of poverty, college attainment, teenage births, divorce, death rates from heart disease and cancer, reliance on federal disability insurance, and male labor-force participation.

As rural America’s economic fortunes declined, so too did the number of banks willing to serve them. Last December, the Wall Street Journal reported that of America’s 1,980 rural counties, 625 don’t have a locally owned community bank (twice as many as 1994); and that at least 35 counties have no bank at all, with about 115 served by just one branch.

Several factors, in addition to economic decline, have contributed to the ever-vanishing supply of banks in rural communities. Passage of the Interstate Banking and Branching Efficiency Act of 1994 (also known as the Riegle-Neal Act) lifted regulations on interstate branching and led to a wave of consolidations that gobbled up community banks – many of which served rural areas.  Between 1997 and 2017, the number of banks in the United States fell from 10,700 to 5,600, with about 97 percent of the decrease accounted for by community banks (banks under $10 billion in assets).[1] In addition, new regulations implemented in the wake of the financial crisis have made it costly for banks to serve the type of customers that predominate in rural communities. For instance, J.P. Morgan estimates that it costs the same to originate a $100,000 loan as it does for one of $1 million.[2] The result is that “small loans to businesses in rural communities today are half the value they were in 2004 (compare this to small loans to businesses in big cities, which have only fallen a quarter) and rural lending levels today are below what they were in 1996.”[3]

Recent Policy Proposals

Postal banking and Opportunity Zones are two recent policy proposals designed to increase the flow of capital to poor rural and urban communities. First proposed by legal scholar Mehrsa Baradaran in 2013, Postal banking would provide basic retail banking services at each of the U.S. Postal Service’s (USPS) 30,000 locations. The idea was revived this past April, when Senator Kristen Gillibrand (D-NY) introduced a bill to create a postal bank that would “effectively end predatory payday lending industry practices overnight by giving low-income Americans, particularly communities of color and rural communities, access to basic banking services that they currently don’t have.” Under Senator Gillibrand’s proposal, the post office would offer small dollar checking and savings accounts; small-dollar, low fee, loans; and domestic and international payment services.

While the aims of postal banking are noble, the idea has several problems – most prominently that the Postal Service has no experience in banking. A recent report by the Treasury Department noted that the USPS lost $69 billion between 2007 and 2018 and is forecast to lose “tens of billions of dollars over the next decade.” If the USPS can’t break even performing their core mission of delivering the mail, why should we expect them to perform any better at banking? Banking is a highly specialized activity that requires resources – physical, human, and technical – the USPS simply does not have. Also, as historian and legal scholar Peter Conti-Brown has noted, a key feature of postal banking is the provision of low-interest rate loans to populations that have a high risk of default. Professor Conti-Brown rightly labels this feature a government subsidy, and notes that when the inevitable defaults materialize, “postal banking will quickly run out of money and require significant governmental support to remain viable.”

Another proposal to spur economic activity in low-income communities was buried within 2017’s tax reform bill and received little attention at the time of passage. An idea with bipartisan origins, the Opportunity Zones program provides a tax incentive for investors to re-invest their unrealized capital gains into Opportunity Funds that are dedicated to investing into economically distressed communities. This past June, the Treasury Department certified more than 8,700 census tracts across the country as Opportunity Zones, of which 23% are in non-metropolitan areas. Through the creation of two new Internal Revenue Code sections, investors can now re-invest unrealized capital gains by making a qualified investment in an Opportunity Fund which allows them to defer and reduce the tax liability on that gain. Investors in Opportunity Zones can also receive tax free gains on their investments.[4]

Regulations are still being drafted that will govern Opportunity Zones and the funds that are allowed to invest in them, and it will take several years before assessments can be made about the program’s overall effectiveness. Critics contend that not all areas tapped as Opportunity Zones are truly in need and that the tax benefits will accrue to only a limited set of wealthy investors. And unlike Postal Banking, Opportunity Zones do not provide direct access to financial services for the unbanked and underbanked. Therefore, the potential benefits of Opportunity Zones will be unevenly distributed throughout the community.

The Farm Credit System

While Postal banking and Opportunity Zones are well-intentioned policies, they suffer from serious design flaws and do not target the unique needs of rural America. Thankfully, solving the rural-banking problem may be as simple as expanding the authority of an existing network of credit institutions that Congress established over 100 years ago to serve the financing needs of America’s agricultural producers.

Few have heard of the Farm Credit System (FCS) but FCS institutions have been serving the credit needs of farmers, ranchers, and other agribusinesses since passage of the Federal Farm Loan Act in 1916. The FCS was the United States’ first government-sponsored enterprise and was setup as a system of farmer-owned cooperatives that would provide long-term mortgage loans to agricultural producers.  At the time, America was largely an agrarian society but most commercial lenders were located in urban centers, just as they are today. These commercial lenders were reticent to lend long-term to farmers and ranchers because they were considered too risky.

The FCS was originally set up as a system of 12 borrower-owned district banks across the country that would provide long-term funds to local Federal Land Bank Associations who in turn would provide mortgage loans to agricultural producers. While the FCS has changed significantly over the last 100 years, the original mission, and basic structure, remains in place. Today, the FCS consists of four banks[5] that provide funding to 69 associations scattered throughout the country. These associations make loans to farmers, ranchers, and other eligible borrowers who are also owners of their local association through a required purchase of stock that is tied to the size of their loans.

The four FCS banks obtain funding from the Federal Farm Credit Banks Funding Corporation that issues short and long-term debt securities on the open market. These securities are the joint and several obligation of the banks in the system and are not obligations of, nor are they guaranteed by, the United States or any agency or instrumentality thereof. However, similar to the securities sold by Freddie Mac and Fannie Mae, securities issued by the Funding Corporation contain an implicit government guarantee.

Now governed by the Farm Credit Act of 1971, the FCS has the authority, subject to certain conditions, to make the following types of loans:

  • Agricultural real estate loans
  • Agricultural production and intermediate-term loans (e.g., for farm equipment)
  • Loans to producers and harvesters of aquatic products
  • Loans to certain farmer-owned agricultural processing facilities and farm-related businesses
  • Loans to farmer-owned agricultural cooperatives
  • Rural home mortgages
  • Loans that finance agricultural exports and imports
  • Loans to rural utilities
  • Loans to farmers and ranchers for other credit needs

A Proposal for FCS Banking

If you drive through any rural area, chances are you won’t have to go very far before you run across a Farm Credit association. In my state of North Carolina for instance, Farm Credit Carolina maintains 32 branches that serve 54 counties throughout the state.[6] Much like the community banks of yesteryear, these branches are mainstays of the local community, with branch employees often living in the same small towns as the borrowers they serve.

Rather than reinvent the wheel, it makes sense to tap into the existing FCS infrastructure to serve the broader banking needs of rural America. Therefore, I propose that Congress amend the Farm Credit Act to allow FCS institutions to provide a greater variety of financial products to a broader base of customers. Specifically, associations should be allowed to offer checking and savings accounts, as well as secured and unsecured loans, to individuals and all businesses (not just agricultural) located in the rural communities they already operate in (I call this idea “FCS banking”).

The main advantage FCS banking has over postal banking, is that FCS institutions already have a long and successful history of performing banking’s most fundamental task – measuring and managing credit risk. In addition, because the FCS enjoys GSE status and the associated funding advantages, associations should be able to issue loans at interest rates below what a commercial bank would offer. Congress may also want to consider granting existing rural community banks the option of joining the FCS, which would provide these institutions with an additional, low-cost, source of funding.

FCS banking has the added benefit of coming with a built-in regulatory structure that can easily adjust to oversee the expansion in FCS activity. The Farm Credit Administration (FCA) is an independent agency in the executive branch of the U.S. government that is responsible for regulating and supervising the Farm Credit System (its banks, associations, and related entities) and the Federal Agricultural Mortgage Corporation (Farmer Mac). Similar to the mandate of federal banking agencies, the FCA ensures that FCS institutions operate in a safe and sound manner and has supervisory and enforcement authorities over these institutions. The FCA does not receive federal appropriations; instead, they fund their operations through assessments on regulated institutions and through interest earned on investments with the U.S. Treasury.

An expansion in the FCS’s product offerings and customer base would necessitate an expansion in the FCA’s supervisory responsibilities. New staff would be hired and existing staff would need training on how to supervise the risks associated with deposit taking and non-agricultural loans. These costs would be covered by additional assessments on regulated institutions.

If associations are to attract deposits, these deposits must be insured, similar to how commercial bank deposits are insured by the FDIC. Thankfully, the Farm Credit System Insurance Corporation (FCSIC) already serves as the government insurer for FCS debt obligations. FCSIC administers the Farm Credit Insurance Fund (Insurance Fund) and collects annual insurance premiums from FCS banks[7]. Under FCS banking, the FCSIC would also serve as the insurer of deposits held at associations (subject to threshold limits). FCSIC’s deposit insurance fund would be funded through annual premiums on deposit taking associations.

Challenges

Expanding the FCS’s lending authority and granting associations deposit-taking authority would be a signification change for a system that is not exactly known for its willingness to innovate. Associations would have to renovate branches and upgrade IT systems, current staff would require additional training, and new staff would need to be hired. All of this comes with increased costs, but the FCS would recoup these costs in short order as they reap the benefits of the low-cost funding that insured deposits provide. Additional regulatory accommodations – and perhaps statutory changes – would need to be made to grant deposit-taking associations access to the Federal Reserve’s Automated Clearing House (ACH) system so that association depositors would be free to make and receive payments from their accounts.

Beyond the technical challenges, politics is the biggest hurdle to implementing FCS banking. The FCS has long been a thorn in the side of commercial banks. The source of this displeasure lies in the FCS’s tax status. Income earned from real estate lending is exempt by law from all corporate income taxes and FCS profits on non-real estate lending are exempt from state and local taxes.[8] In addition, bonds, debentures, and other obligations issued by the FCS banks are exempt from all taxes other than federal income tax, thereby making them attractive investments and providing the FCS with a lower cost of funding.

Commercial banks also complain that the FCS has strayed too far from its original mission of lending to small farmers, and in so doing they’ve encroached on the banks’ territory. As an example, they cite one FCS bank’s (CoBank) $725 million loan to Verizon Wireless to complete its purchase of European cellular company Vodaphone in 2013. This loan prompted the Independent Community Bankers of America to write a letter to the FCA to ask why a multinational telecommunications company qualified for “tax-advantaged financing from a government-sponsored enterprise (GSE) that provides credit and other services to agricultural producers and farmer-owned cooperatives.” CoBank defended the loan by noting that they have the authority to support companies that seek to provide modern communication services to rural communities.

The banking industry’s frustration with the FCS led the American Banking Association to launch the Reform Farm Credit campaign, replete with a website that notes the campaign’s mission is:

  1. To educate Americans about how the Farm Credit System, a government-sponsored enterprise, no longer serves the people it was created to serve and puts American taxpayers at risk by making large, non-agricultural loans;

  2. To advocate for better oversight and significant reforms of the Farm Credit System by the US Congress.

Addressing the Banks’ Complaints

Banks complain that the FCS lends to non-agricultural businesses – in violation of their original mission – but it is exactly this type of lending that is needed to jump-start rural communities. To assuage the banks’ concerns, FCS banks would be restricted to serving customers that operate exclusively in rural communities (as defined by some objective standard, e.g., census tracts).

Banks also complain that in many areas, they can’t compete with the FCS due to the latter’s tax treatment and funding advantages (derived from their GSE status). Similar to Professor Conti-Brown’s critique of postal banking, these advantages amount to a government subsidy, and should the FCS ever get into trouble, it will require a taxpayer bailout. In fact, the FCS has been bailed-out once before, in 1987, in the midst of the farm crisis. A combination of high interest rates and oil prices, a strong dollar, and collapsing commodity prices – due in part to an export embargo against the Soviet Union – led to a wave of farmer defaults that led Congress to pass a $4 billion bailout of FCS.

While the potential for an FCS bailout remains – with or without FCS banking – some perspective is in order. One $4 billion bailout over a 100 year period is a pretty good track record when compared to the history of commercial banks in this country. In 2008 alone, Congress bailed out the largest banks to the tune of $700 billion – more than twice the amount of current FCS assets.

Allowing the FCS to diversify their lending portfolio and accept deposits will make the system less reliant on the agricultural sector and the booms and busts that come with it. When you combine diversification with effective supervisory oversight by the FCA, the risk of a bailout is low. And if government support is ever required, the amount will surely pale in comparison to the extraordinary support too-big-to-fail banks received in 2008.

Conclusion

Expanding the Farm Credit System’s authority is not a magic bullet that will cure all of rural America’s ills. The FCS faces the same competitive pressures as commercial banks, and like banks, has experienced a wave of consolidations that calls into question the system’s willingness to serve small farmers. Allowing Farm Credit associations to serve more customers with more services can stem this tide and strengthen the overall health of the system. More importantly, it can provide affordable banking services to rural communities that desperately need it. Rather than rely on a government agency with no banking experience, or the potential trickle-down benefits of tax-breaks for the wealthy, why not lean on a system that has functioned well for over 100 years? If Congress is willing to stand up to the bank lobby, they will see the benefits clearly outweigh the risks.

 

 

[1] https://www.federalreserve.gov/newsevents/speech/quarles20181004a.htm

[2] https://www.wsj.com/articles/big-banks-cut-back-on-small-business-1448586637?mod=article_inline

[3] https://www.wsj.com/articles/goodbye-george-bailey-decline-of-rural-lending-crimps-small-town-business-1514219515?mg=prod/accounts-wsj

[4] https://fundrise.com/education/blog-posts/what-are-opportunity-zones-and-how-do-they-work

[5] FCS banks include CoBank, ACB; AgriBank, FCB; AgFirst Farm Credit Bank; and Farm Credit Bank of Texas

[6] https://www.carolinafarmcredit.com/locations.aspx

[7] https://www.fcsic.gov/about/general-information

[8] https://www.aba.com/Tools/Function/Ag/Documents/Horizons2006ELY.pdf

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