Scrap Regulations that Thin the Ranks of Small Banks

Regulatory burdens allow big banks to flourish at the expense of their smaller competitors. Regulations cost more than they are worth, and getting rid of regulations will help financial institutions of all sizes serve customers effectively and affordably.

Regulatory burdens allow big banks to flourish at the expense of their smaller competitors. This has become so obvious in the aftermath of the Dodd-Frank Act that even Goldman Sachs chairman Lloyd Blankfein admits to it.

The financial industry is an "expensive business to be in if you don't have the market share and scale," Blankfein remarked in a recent speech. Thanks to regulatory and technology demands, he said, "the barriers to entry [are] higher than at any other time in modern history."

Blankfein's comments were made in the context of Goldman's institutional client services business. But these concerns are broadly applicable across the financial services industry. There is nothing wrong with big, established banks gaining market share because they offer the mix and quality of products and services that customers want. There is something wrong, however, with these large banks beating off their smaller, newer rivals with a club fashioned by Washington legislators and regulators.

The Senate Banking Committee has considered the regulatory burden on community banks in two recent hearings. At one of these hearings, community bankers and credit union leaders testified about how their lending practices had been changed by Dodd-Frank.

Before Dodd-Frank, financial institutions were able to make loans to customers with whom they had long relationships and therefore had good reason to anticipate would be willing and able to repay. Now financial institutions are compelled to turn away these same customers because their loans would carry too much regulatory risk. Long-term, mutually beneficial banking relationships are crumbling as new regulations mount.

The federal regulators who appeared before the Banking Committee seemed unwilling to work to understand the depth of the problem. They complained that proposed legislative changes to help them better anticipate the costs and benefits of regulations before they adopt them would make writing rules more difficult.

It is true that rulemaking would be slowed if regulators are required to do the additional work upfront to answer the critical question of whether the benefits of a new rule outweigh the costs. But as I described in a 2012 study, the federal financial regulators charged with implementing Dodd-Frank are not doing the economic analysis that is required of other regulators. Doing so could save regulators the hassle of having to redo rules down the road when it becomes apparent that they are doing more harm than good.

In a new Harvard Kennedy School study of the impact of regulations on community banks, authors Marshall Lux and Robert Greene urge policymakers to embrace economic analysis as a way to "ensure better-designed regulation in the future and avert unintended consequences that jeopardize lending market vitality." The paper discusses the important role that small banks play in the lending markets and finds that community banks' share of U.S. banking assets has dropped more than 12% since the passage of Dodd-Frank. Community banks, especially the smallest ones, also have seen their market share decline in a number of lending markets.

Yet Sen. Elizabeth Warren posited at the Senate Banking Committee hearings that small banks' calls for regulatory relief are in fact veiled attempts by large banks to chip away at financial reform. After all, she argued, Dodd-Frank exempted community banks from certain provisions and authorizes regulators to make additional adjustments.

The problem is that exemptions don't always work. As Sen. Jeff Merkley explained, requirements can trickle down from big to small banks. He described how the following conversation often occurs between regulators and community bankers:

"Well, you must do X."

"Well, why is that?"

"Well, it's a best practice, and so you really don't legally have to do it, but we expect you to do it."

This scenario is consistent with the findings of a February 2014 survey of roughly 200 small banks published by the Mercatus Center at George Mason University. As one community bank respondent wrote, "Rules are written for the largest institutions in the country, yet the smaller institutions have to abide by the same rules."

Even when small banks receive explicit exemptions, we found that rules nonetheless impose additional burdens upon them. For example, although the Bureau of Consumer Financial Protection does not directly supervise community banks, the new agency was one of the biggest concerns for the small banks in our survey. Similarly, nearly half the banks in our survey reported being affected by the Durbin Amendment, a price cap on debit card processing fees that expressly does not apply to small banks. Small banks also expressed considerable frustration that Dodd-Frank's regulatory burdens were not producing any offsetting benefits for bank customers.

Poorly crafted regulations may warm some people's hearts because they enjoy sticking it to the financial industry. But the real victims of such regulatory vengeance are the individuals, companies, and communities that rely on banks of all sizes.

We should get rid of regulations that cost more than they are worth. This is a sensible way to ensure that financial institutions — large, small, well-established and new — can serve customers effectively and affordably.