The opposite of Dodd-Frank

The Canadian government has initiated a five-year review of financial-sector legislation. A Department of Finance consultation paper is asking how the financialsector framework could best promote competition, including by encouraging new entrants and fostering the growth of small entities. The paper also asked whether lessons could be learned from other jurisdictions to inform how to address emerging trends and challenges. One place to look that could be particularly enlightening is the U.S. experience with community banks, especially in light of President Donald Trump’s executive order to review and scale back the bank regulations introduced in the 2010 Dodd-Frank Act.

Some commentators have argued that Dodd-Frank’s restrictions on banking activities was a way to ensure a major financial crisis could never happen again, an argument so absurd that any first-year history student could debunk it. In fact, paring down the regulatory requirements and reducing the compliance burden placed on banks could actually help financial stability by facilitating the entry of more community banks into the U.S. market.

Community banks are small, regional banks that typically specialize in lending to local businesses and consumers. Definitions of community banks vary. Some U.S. regulators such as the Federal Reserve classify any bank with under $10 billion in assets as a community bank. Community banks are widely acknowledged to be important players in lending to small businesses and farms, and rely more on relationship lending A Canadian government Department of Finance consultation paper is asking how the financial-sector framework could best promote competition. than do larger banks, which rely on computerized formulas rather than relationships to determine creditworthiness.

A widely held belief among financial regulators is that large, complex and interconnected banks capital requirements and additional regulations, such as stress tests.

It would seem logical that more competition from smaller banks would be welcome as this would reduce the market share of large banks, thus curbing shows that smaller banks face a heavier compliance burden than their larger counterparts. There are signs this may be the case with Dodd-Frank despite its regulatory emphasis on the largest institutions. A working paper by Marshall Lux and Robert Greene, of the Mossavar-Rahmani Center for Business and Government at Harvard Business School, shows that the trend of declining market share for community banks could have accelerated because of Dodd-Frank. The decline in the share of their commercial assets almost doubled to 12 per cent from the time the act was passed in 2010 to the second quarter of 2013 compared to the rate between the second quarters of 2006 and 2010. According to a 2015 Federal Reserve article, the rate at which new banks are being formed fell from an average of approximately 100 per year since 1990 to an average of three per year since 2010.

If it is true that large banks are a bigger threat to financial stability, easing the Dodd-Frank regulatory requirements could lower risks to the financial system — in addition to offering other benefits such as more lending to business that would strengthen the broader community. A recent Wall Street Journal article reported there is already renewed interest in forming community banks because of the prospect of a lower regulatory burden. Regulators are already seeing an increase in new bank applications. The lesson for Canada would seem to be that, if want to foster competition and encourage small banks, we should be looking to lighten their regulatory burden. that: “A key factor contributing to the difficulty of raising capital by new startups is the fact that individuals who sell existing investments and reinvest in others must pay tax on any realized capital gains.”

However, despite the deduction in capital gains taxes by the previous Liberal government, Canada still maintains one of the highest capital gains tax rates among OECD countries. And what’s more, 11 of the 34 OECD countries do not impose any capital gains tax.

Other small, open economies such as Switzerland and New Zealand recognize the economic benefits of having no capital gains tax. Not only does the absence of the tax improve the allocation of investment in countries, it creates stronger incentives for entrepreneurship and investment, both of which are critical to improving any economy.

At a time when both the rate of business startups and the expectations for longterm economic growth are declining in Canada, increasing the capital gains tax is exactly the opposite of what this government should be contemplating.

If Prime Minister Justin Trudeau and Finance Minister Bill Morneau were truly dedicated to longterm economic growth and fostering innovation, they would follow the lead of their Liberal predecessors and reduce — rather than increase — the capital gains tax rate.