The circulation of liquidity in an efficient financial system is undoubtedly one of the primary pillars of economic progress. For the ever-changing dynamic of the current United States economy, a well-functioning financial system is fundamentally required for growth. However, the influence of the financial system is double-edged, and the recent financial crisis in 2008 spurred on an attempt by Congress to curb any future crisis from recurring. The Dodd-Frank Act entered the scene in 2010 as the largest piece of economic reform since the Great Depression—a care package of regulation to fix the problems of the financial system. In the six years since Dodd-Frank’s passing, only 77 percent of the 390 rules have been finalized. However, even in the rules finalized thus far, it is already clear that community banks have been affected by Dodd-Frank’s unintended consequences.
Community banks—banks whose total assets are under $10 billion—make up 99 percent of all banking institutions throughout the United States. However, due to the nature of their operations, the total assets held by community banks are only 20 percent of all assets in the banking industry. While 1 percent of banks hold 80 percent of all bank assets, the vast majority of banks are included in Dodd-Frank as if they contribute to the problem of systemic risk. Furthermore, the location, nature of operations, and model of community banks greatly differ from the larger 1 percent of institutions. Naturally then, as Dodd-Frank regulates in broad strokes across the industry, it has been labeled by some community bank presidents as an “omnibus package of legislation that does more harm than good.”
This V&C Young Scholar report on Dodd-Frank seeks to identify how Dodd-Frank impacts community banks. Specifically, this report focuses on the relevant provisions of Dodd-Frank that apply to community banks and analyzes the impacts using primary research with bank officials and other resources. The report elaborates on two significant repercussions. First, Dodd-Frank creates a double-bind for community banks by forcing them to grow or merge, while the cost of regulation threatens the sustainability of the banking model. As a consequence, local economies who are primarily served by community banks lose their access to the circulation of liquidity. In turn, this threatens the growth of rural economies. Second, Dodd-Frank excludes and isolates certain groups in society from loan eligibility due to legally restrictive lending standards. Rules enacted by the Consumer Financial Protection Bureau (CFPB) directly conflict with the normal practices of community banks, prohibiting lending practices that were otherwise normal and relatively risk-free.
Before elaborating on the two repercussions, the context surrounding the dynamic of the banking industry is worth noting. Of the several conditions surrounding community banks, there are three factors that stand out as the most prominent. First, community banks have been consolidating since the 1980s. Over the past 30 years, 58 percent of community banks have exited the market, with 80 percent of those having merged into larger institutions. However, since Dodd-Frank’s enactment, the pace of consolidation has doubled. Additionally, the market share for community banks is also declining as they make up less of the percentage of loans—even though they make up the majority of institutions. Second, community banks are the primary financial institution for rural areas. Rural regions represent 58 percent of branches and 49 percent of deposits for community banks. Third, on a functional level, community banks operate on a relationship-banking model which is significantly different from larger institutions. Community banks add context among the variables by which they make lending decisions. This includes prior history with the customer, referrals, and the case’s unique circumstances. The relationship-banking model has been widely acknowledged as the primary feature of community banks.
The first repercussion is the unintended consequence of increasing the cost of compliance for community banks. Economies of scale exist within the financial industry. A banking institution’s marginal profitability increases its operational efficiencies with growth. Consequentially, community banks earn a smaller return ($1.09) for every dollar spent on operations, compared to larger institutions ($1.71). This inherently results in a disproportionate impact of compliance costs on smaller banks, as has been explicitly noted by Janet Yellen. Based upon the evidence that can be gathered thus far, the cost of compliance is threatening the community banking model as smaller institutions do not have the resources to handle increased compliance costs. Thus, community banks are forced to grow or merge. However, the growth of local economies has been relatively stagnant, making a merger the likely future for a significant amount of community banks. Consolidation will continue at an increased pace due to Dodd-Frank’s set up of an artificial economies of scale. As a result, local and rural communities suffer from the lack of relationship-based lending by which their economies thrive.
The second repercussion is the unintended consequence of isolating certain segments in society as a result of new lending requirements by the CFPB. The CFPB, an administrative agency empowered with the discretionary authority to interpret rules and mandates for financial institutions, set up Qualified Mortgage (QM) and Ability-To-Repay (ATR) standards that dis-incentivizes and legally prohibits certain lending practices. QM standards make certain loans more vulnerable to future lawsuits by the lendee, which intentionally dis-incentivize certain loans from banks. However, QM standards are linked to ATR standards which legally prohibit banks from making loans to individuals that fail to provide documentation that satisfies the CFPB’s criterion. The required documentation includes pay history and future pay estimates, making certain groups such as the recently unemployed/retired ineligible for loans. Small and medium enterprises as well as sole proprietorships have a particularly difficult hurdle given the amount of audits and steps required for loan eligibility. As a result, crucial segments of society are now excluded from the circulation of liquidity that is essential to their success and the survival of local and rural economies.
As a solution to the problems created by Dodd-Frank’s repercussions, the report notes that community banks were not the cause of the financial crisis. Though they were affected, the nature of community bank lending practice does not incur the risk of the securitization process, which fundamentally led to the crisis. Therefore, community banks ought not to face regulation where it is not appropriate. The report proposes a specific amendment to Dodd-Frank: exclude community banks from the inapplicable mandates and remove QM and ATR standards when 100 percent of the loan is held internally. The report also endorses the TAILOR Act, proposed by Scott Tipton (R-CO), as an effective way of addressing the CFPB’s discretionary authority to mandate new rules. The proposed amendment will remove the compliance costs that threaten the banking model and will also remove the harm of QM/ATR standards while preventing any potential risk. In this way, financial stability is maintained and community banks are able to uniquely serve their economies as they do best.
In conclusion, Dodd-Frank represents a culmination of an incrementally increasing micro-management policy toward the financial industry. Though it attempts to solve a large-scale issue, the large-scale approach overlooks fundamental differences that make up the U.S. economy. The diversity, uniqueness, and tailored service that different financial intermediaries provide to the United States economy on all levels is a hallmark of America’s financial economy as a whole. Community banks will suffer under the added cost of compliance, simply due to the nature of their operations and their ability to handle compliance. Local economies benefiting from their service will stagnate more than they are currently. Segments of society who are isolated from lending will also suffer from being excluded the opportunity of long-term planning that comes with lending. Community banks represent the dynamic nature of a diverse economy, and any financial reform ought to reflect that reality.
Read the full paper at this link: dodd-frank_repercussions-on-community-banks-and-local-lending-final