RegTech Intelligence

Dodd-Frank: smaller players and the cost of regulation

The plight or health of community banks has become a key weapon in the war between supporters and critics of Dodd-Frank and even financial regulation in general. The unmistakable decline in the number of community banks is used by many as an example of why the 12,000+ page legislation is flawed, as it supposedly hurts the banks that did not contribute to the 2008 financial crisis in response to which the legislation was designed.  Others point to the areas in which community banks could be said to be performing better.  The issue is a complex one, and is mobilised often as part of the economic arsenal for political warfare.  But does Dodd-Frank really have such an impact on these banks?

Small community banks are an important part of the US economic ecosystem.  In fact, small banks make up the majority of the industry as 98% of institutions have fewer than $10 billion in assets and 89% have fewer than $1 billion.  From the friendly and local service they offer – which appeals to many customers – to the hard numbers of the local, agricultural and small business projects to which they loan, these banks perform functions that larger banks simply do not.  Which is why it is worrying to learn that a community bank has closed every day, seven days a week, since the autumn of 2008.  There are reasons to believe that this decline is caused, at least in part, by regulations like Dodd-Frank.

Or, is Dodd-Frank just being blamed for a decline that has been in progress for decades?  In the 1880s, according to the Federal Deposit Insurance Corp, there were more than 18,000 institutions.  In 2015 there were just over 6,400.  Dodd-Frank is one part of a larger regulatory burden, which has been increasing in the past few decades.  Due to its size, scope and complexity, it has caused many banks, both large and small, multiple problems and has effectively become the ‘poster child’ for the problems of overregulation.  If regulation is drastically contributing to the decline of community banks, it seems unlikely that it is only Dodd-Frank’s fault.

Regulation, logically, seems more painful for smaller banks than for larger ones if not scaled appropriately.  The compliance costs with which banks with over $10 billion in assets can cope, will be rather more taxing for those under that threshold.  In theory, then, the compliance requirements should also be scaled and, in fact, Dodd-Frank does include many exemptions for those with under $10 billion in assets.  But, at this point, there is an important question to be asked.  Regulation is designed to protect the customer and the financial system.  Just because a bank is smaller, do they pose less of a threat?  If not, then it appears they are ‘too small to succeed’ in a world where a safer financial system is a priority.  If they are less risky, then surely scaled regulation means that proportionally large and small banks should face the same issues and suffer the same consequences. This is not necessarily the case – the cost of a small compliance function in a small bank can be comparatively more expensive than the cost of a large compliance function at a large bank due to economy of scale.

A study from Harvard University shows that community banks have been particularly hurt by Dodd-Frank.  According to the paper, since Dodd-Frank has been put into effect, the share of total assets controlled by banks with less than $10 billion in assets has shrunk twice as fast.  The worry is that consolidation – the process of combining the assets and liabilities of multiple entities into one – is on the increase and, while that is not inherently a bad thing, if it is occurring for the wrong reasons, it might damage the sector. Consolidation, on average, has not increased much since the introduction of Dodd-Frank, from 3.5% a year on average before to a 4% a year since.

Without a doubt, the cost of compliance is increasing with the influx of new and complex regulation since 2008 and, to some extent, that will hurt the smaller banks.  However, there are many other factors involved that could be contributing to the low number of banks and the increase in consolidation more than overregulation.  Low inflation rates, for example, and the general state of the economy.  Fewer banks are being created and others are being forced to merge or are being bought by larger banks.  A current economic climate of low growth, which is being discussed as an issue by many global leaders, for instance at the latest G20 summit, could be a more justifiable cause for the difficulties community banks seem to be facing.  Macroeconomic conditions such as these are likely to be a contributing factor.

Some argue that this decline is part of the natural battle being faced by smaller banks; they are unable to compete with the larger banks, for example in coping with the new regulatory requirements that have grown from a new standard for financial safety.  Clients want a safer economic system and more protection, which results in the need for an increase in regulation and heightened compliance costs, which some community banks simply cannot meet.  This is an example of how bigger banks benefit from economies of scale, and the small community banks simply cannot.  Issues of succession also can cause closure if they are kept within the family.

Besides, data exists which suggests that community banks are doing reasonably well, even post Dodd-Frank. Since 2010, lending has actually increased by all but the smallest banks, which indicates good health for most community banks.  In fact, the average number of bank branches per community bank has increased since 2010, also painting a positive picture of health.

This is not a debate of whether small community banks should naturally struggle or not.  It is a question of whether regulation – Dodd-Frank in particular – has unnaturally caused an increase in their pains.  The answer is elusive, the costs are difficult to weigh and the causes are almost impossible to decipher.  It is possible that Dodd-Frank has had some negative impact on the smallest banks, as it has on all banks, but how significant this is compared with the other factors and other sized banks will be discussed by economists, politicians and historians for many years to come.

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