Will Dodd-Frank Kill Small Banks?

Local bankers fear the Dodd-Frank law passed in 2010 will hasten the demise of small banks and lead to the “Walmartization” of consumer banking.

“In mid-Missouri, generally, I think we’ll probably see some smaller banks acquired by bigger banks, first of all,” says John Howe, Missouri bankers chair and professor of finance at the University of Missouri. “Second of all, I think it’s going to have a somewhat depressing effect on the profitability of banks and their overall financial health.”

Although there will always be a place for community banking, there will be consolidation in the industry, but how much is anybody’s guess, says Kim Barnes, president and chief operating officer of The Callaway Bank.

“Do I think it will be more difficult?” Barnes asks. “Yes. There is a certain size and scale that [banks] simply will have to get to in order to handle the new changes, and a little community bank that has one branch in one location in a small town will likely struggle to survive on its own.”

In 2010 Congress passed the Wall Street Reform and Protection Act, known as Dodd-Frank, a move that rivaled earlier banking regulatory changes such as the dismantling of most of Regulation Q in the 1980s and most of the rest of the Depression Era’s Glass-Steagall Act in the 1990s. Dodd-Frank intended to curb irresponsible practices by the Wall Street financial institutions that were judged to have caused the Great Recession of 2008.

But all banks are not alike. “The notion was that the regulation was either wrong or too small, and that led to the crisis that started in 2008,” Howe says. “However, the financial crisis was largely brought on by the large global banks, and yet all banks have kind of been painted by that brush.”

One of Dodd-Frank’s most contentious regulations is the Volcker Rule, named after former Fed Chairman Paul Volcker, who proposed it while serving as chairman of the President’s Economic Recovery Advisory Board. The rule prohibits banks from owning, investing or sponsoring hedge funds, private equity funds or any proprietary trading operations for their own profit. In effect, under the Volcker Rule, banks can no longer make speculative trading decisions that do not benefit clients.

“The very largest banks engaged in some speculative trading with their own money,” Howe says. “When that turned bad, then the bank became, if not insolvent, then at least stressed. And that had some negative spillover effects on the economy and the banking system in general.”

The business of community banking
Small community banks such as those in Columbia do not engage in selling high-risk products such as mortgage loans with little or no documentation or teaser rates, Barnes says. They stick to the basics of accepting deposits and making loans.

Nor do community banks involve themselves in investment banking activities such as trading in stocks, derivatives and hedging. Derivatives are financial instruments that derive their value from something else, such as credit default swaps, in which the buyer pays the seller a fee and receives a payoff in the event of a loan default. Likewise, hedging is an action taken to offset a loss in a companion investment, which in effect is betting against one’s own speculation.

Unlike large banks, community banks tend to embrace transparency, openness and full disclosure, and their banking activities are all open for review, Barnes says. Why? Community banks want their customers to make sound decisions. A small bank’s health depends on it.

“We do our business in a relationship sort of way,” Barnes says. “We don’t do it in a mass advertising way: tantalize you, get in the door and turn on the charm. That’s not how community banks do business.”

With a new layer of scrutiny, Dodd-Frank weakens the community banking relationship, Barnes says. “Our ability to do relationship banking is inhibited to some degree by additional regulation because it doesn’t give us the flexibility to maybe create a product for you that fits you best. The added burden of regulation makes for more vanilla products.”

And another advantage of a smaller bank: It can make decisions locally, while a larger bank can’t, Barnes says. “If you have a branch whose manager can’t make it right, then that’s not a community bank. That’s what’s frustrating about all the layers of regulation. The person coming from Washington, D.C., to look at our bank and examine what we do and how we do it doesn’t know our client base. We do.”

Size and scope of Dodd-Frank
The daunting size of Dodd-Frank makes local bankers wary. Glass-Steagall was 30 pages long, and Dodd-Frank is 1,100 pages, Barnes says.

In addition to potentially generating hundreds of other new banking rules, Dodd-Frank created the new Consumer Financial Protection Bureau to advocate for consumers and a Financial Stability Oversight Council to fend off future financial crises. The law also led to newly minted agencies in the Treasury Department and Securities and Exchange Commission that now oversee the insurance and credit rating agency industries.

Michelle Muth Person, a spokesperson for the CFPB, declined to comment on the new Dodd-Frank provisions and their potential impact on local banks. However, she said in an email that senior CFPB leadership has met regularly with community bankers and other stakeholders since the department was formed, including a meeting in July 2012 with community bankers from 20 states, including Missouri.

The department also formed a Community Bank Advisory Council to receive input from bankers in September 2012. The council has two members from Missouri: Donald Giles of Armed Forces Bank and Melany Kniffen of Southern Commercial Bank.

A Treasury Department spokesperson was unable to provide comment or information.

Small banks are complaining the loudest about the increased regulatory burden, which makes it much easier for large banks to handle the increase in regulatory costs brought on by the legislation than it is for small banks, Howe says.

“The intentions of Dodd-Frank may be good, but the costs are very large,” he says. “Those smaller banks are going to suffer.”

Larger banks have economies of scale and greater resources that allow them to be more adept at handling complex regulation, Barnes says. That’s because for a bank, regulatory burden is largely a fixed cost, Howe says, and the cost of complying with the regulations doesn’t increase nearly as fast as bank size increases.

A small bank, he says, holds about $100 million in deposits or less. The Callaway Bank, for reference, has $299 million in deposits. Unfortunately, the CFPB uses deposits of $10 billion or less to define small banks, Barnes says, which covers most of the banks in the Midwest.

In response, CFPB spokesperson Michelle Person says Dodd-Frank set the $10 billion figure, not her agency.

“It’s the definition of banks that we examine and supervise,” she says. “We examine and supervise banks with assets of $10 billion or more.”

Every regulation placed on banks translates into costs for local banks, Barnes says, and Dodd-Frank’s finalized rules will take an estimated 24 million hours to comply with. For Callaway Bank alone, one recent regulation added one hour and 15 minutes to process a mortgage loan, and the bank processes at least 100 loans a month.

“When a bank gets pretty big, those regulatory dollars are really a very small percentage of the cost of doing business,” Howe says. “For a small bank, these costs are not in some sense proportionately smaller because they still have to fill out a bunch of forms and whatever else is involved in the regulations.”

Carrying the burden
The burden of the potential new rules, the uncertainty as to how and when they will be approved and their speed of implementation worries local bankers, Barnes says. Dodd-Frank has generated nearly 400 rulemaking items across 20 government agencies. Of those, 133 are done, 132 are in process, and the rest are in some other phase of development.

In addition, in the past a new rule might have an implementation period of six months or a year. Under Dodd-Frank’s accelerated rulemaking, the implementation time limit has compressed some timelines to as few as 30 days, which means software must be reprogrammed, financial products must be retooled, staff changes must be made and training must be done rapidly.

“All of that can be done for one thing, but just one, not 130,” Barnes says. “For us, that means a lot more money in software and tools, a lot more in overhead and a lot less time actually spent doing business.”

One notable local Dodd-Frank casualty is Shelter Financial Bank, which decided to shut its doors in response to the legislation. “Dodd-Frank dramatically expanded the web of intricate requirements,” says Ron Wheeling, president and CEO of Shelter Financial Bank. “It was the final straw and a very large part of the decision to exit the banking business.”

Shelter Bank’s closure displays the reality of the problem. “It’s one thing when people say, ‘Oh, everybody bitches and moans about regulation,’” Howe says. “But it’s another when they say, ‘Oh, I guess they really mean it when they’re shutting down the bank.’ If that were profitable, they wouldn’t be shutting it down.”

And if Dodd-Frank has bankers concerned, another worldwide future regulatory change looming on the horizon has them absolutely livid. Known popularly as Basel III, the Third Basel Accord is a global regulatory standard that would require banks to meet new stringent tests for capital, stress and market liquidity. Now under discussion by U.S. regulators, Basel III will require banks to raise more money proportionally through stock and less through deposits, and it will increase their cost of doing business, Howe says.

Basel III began as a proposal aimed at systemically important financial institutions, the big global banks that are considered too big to fail, Howe says. “Basel III is not going to go away. As the discussion about it has progressed, there has been more and more talk of pushing this down to all banks, not just the big banks.”

What remains to be seen is whether, much like radiation treatment for cancer that leaks into nearby healthy tissue, the financial medicine imposed on large banks will trickle down and poison healthy smaller institutions.

“There is no common sense left in the banking regulation arena,” Wheeling says. “I wear a size 8.5 shoe. Shaq wears a size 16. If we were banks, we would both be required to make due with a size 12. It’s just pitiful.”