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, pa ring 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 than do larger banks, which rely on computer- ized formulas rather than relationships to determine creditworthiness.
A widely held beli e f among f i nancial regulators is that large, complex and interconnected banks present a greater threat to financial stability than do smaller institutions. As part of the global reforms introduced following the financial crisis, large banks can be designated as “systemically important” based on the premise that their failure could threaten the stability of the financial system as a whole. The post- crisis regulations subjected these too-big-to- fail banks to higher capital requirements and additional regulations, such as stress tests.
It would seem l ogical t hat more c ompetition from smaller banks would be welcome as this would reduce the market share of large banks, thus curbing their risk to financial stability. However, Dodd- Frank seems to be having the opposite effect, since the increase in regulatory burden might just be reducing the market share of community banks.
Empirical evidence, including analysis by Federal Reserve economists on whether size affects the ability of banks to cope with regulatory compliance, shows that smaller banks face a heavier compliance burden than their l arger 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 l arge 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 al r e ady 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.
REGULATIONS INTENDED TO PROMOTE STABILITY HAS LED TO FEWER COMMUNITY BANKS.