Small Banks Struggling Under the Weight of New Regulations

While many of the provisions of the Dodd-Frank Act and other regulations are aimed squarely at the “too-big-to-fail” banks, they are having a profound effect on the little guys, and not in a good way.

In fact, many small community banks and credit unions are finding the regulatory burden too great to bear on their own, so they are merging with other banks.

Sharon Weinstein, who heads Deloitte Corporate Finance's financial institutions practice, says we can expect the pace of banking mergers and acquisitions to pick up near the end of the year and escalate throughout 2013. “If you look at the headwinds a lot of these banks are facing, especially some of the smaller institutions, you've got a lot of market volatility, global weakness, and economic and political uncertainty,” she says.

Financial reform continues to weigh on banks, she adds, and stirred into the troubling mix are stress testing, dividend restrictions, and increased capital requirements. “All this is against a backdrop where we are still in a weak housing market,” Weinstein says. “Asset quality has improved, but is still weak across the board, and we are seeing very tepid loan growth. Big picture, there are a lot of issues facing the banks.”

“This is why the bank boards are so burned out from either navigating the downturn starting in 2008, or still struggling to meet capital hurdles and compliance costs,” Weinstein says. “Many of the rules have yet to be written in the Dodd-Frank Act, and the [Consumer Financial Protection Bureau] still remains a wild card. All of this will be a driving push for renewed M&A activity going forward.”

“Community banks really feel like they are spending more time and resources on regulatory compliance that really is out of proportion to their primary business, which is lending in their communities,” says Karen Thomas, senior executive vice president of government relations and public policy for the Independent Community Bankers of America. “It is never one regulation that's the problem; it's the cumulative effect of them. It is like snowflakes on the roof. A few snowflakes fall, then a few more and finally there is one snowflake too many and the whole thing collapses.”

ICBA has been lobbying on behalf of the Communities First Act, a package of legislative initiatives that would offer regulatory and tax relief for community banks. Thomas says that rather than put all effort into that one bill (which has nearly 80 co-signers in the House, but only a handful in the Senate), they look for opportunities to pull provisions and pair them with other legislation.

That included additions to the JOBS Act that increased the current 500-shareholder threshold for SEC registration to 2,000 for financial institutions and increased the deregistration threshold for financial institutions from 300 to 1,200 shareholders. “[the provisions] allow those community banks to deregister and save all those compliance costs that go with being a public company,” Thomas says.

In recent testimony before a House sub-committee on financial industry bailouts, Douglas Fecher, CEO of Wright-Patt Credit Union in Ohio, said that “credit unions face a crisis of creeping complexity with respect to regulatory burden.”

“It is not just one new law or revised regulation that challenges credit unions, but the cumulative effect of all regulatory changes,” he said. “The frequency with which new and revised regulations have been promulgated in recent years and the complexity of these requirements is staggering,” he said.

Since 2008, he estimated that credit unions have been subjected to in excess of 120 regulatory changes from at least 15 different federal agencies.

“The burden of complying with ever-changing and ever-increasing regulatory requirements is particularly onerous for smaller institutions, including credit unions. This is because most of the costs of compliance do not vary by size, and therefore proportionately are a much greater burden for smaller as opposed to larger institutions. If a smaller credit union offers a service, it has to be concerned about complying with virtually all of the same rules as a larger institution, but can spread those costs over a much smaller volume of business.”

Another difficulty for banks, says Weinstein, are the Basel III capital requirements agreed upon by the Basel Committee on Banking Supervision in 2010. Basel III rules, when they begin to take effect next year, will require banks to carry more, and higher-quality, capital on their balance sheets. Smaller banks have protested that a safeguard against mega-bank failures will arbitrarily apply to them as well. In fact, they argue, big banks could just draw the extra capital by taking an advantage they don't have—issuing more stock.

“Simply put, the Basel III capital proposals by the federal bank regulatory agencies are a disaster for the commercial banking industry—especially for community banks.”

—Cam Fine,

President and CEO,

Independent Community Bankers of America

“The Basel III capital proposals by the federal bank regulatory agencies are a disaster for the commercial banking industry—especially for community banks,” says Cam Fine of the Independent Community Bankers of America (ICBA). “Any bank not designated a Systemically Important Financial Institution (SIFI) by the Financial Stability Oversight Council should not be subject to the Basel III capital guidelines as currently proposed. Basel III was never meant to apply to the smallest banks in our nation. In fact, we don't think it should be applied to any bank below $50 billion in assets.”

Another regulation that could hinder small banks is the Durbin Amendment to the Dodd-Frank Act. It limits interchange fees, also called “swipe fees,” that banks and credit unions charge retailers for debit card transactions. Community banks fear that even though smaller institutions are exempt from the limits, retailers may increasingly steer consumers to those issued by large banks.

Needed Protections

While regulations are piling up on small banks, an important safety net may be going away. Community banks are aggressively pushing for the extension of the Transaction Account Guarantee program, an insurance program that covers about $1.4 trillion worth of deposits. Created in the midst of the financial crisis, it expires at the end of the year. The ICBA is among the groups arguing that a two-year extension is needed because its protection of noninterest-bearing accounts will help level the playing field between small and larger institutions that say they no longer need it.

CRITICAL ISSUES

The following is excerpted from a report issued by the American Bankers Association on “Critical Issues” facing community banks from the Dodd-Frank Act.

Basel III

The capital changes under the Dodd-Frank Act bring the United States close to convergence

with the international capital standards outlined in Basel III. Public statements from U.S. bank

regulators confirm their intention to harmonize U.S. regulations with international standards, and

even exceed them. Although the changes under Dodd-Frank apply mostly to large institutions,

Basel III requirements will likely apply to all banks. ABA anticipates comprehensive revisions to the

risk-based and leverage capital frameworks as a result of Dodd-Frank and recent pronouncements

from the Basel Committee.

FDIC

The Dodd-Frank Act made significant changes to how the Federal Deposit Insurance Corporation is

funded and how large the deposit insurance fund can be. It raises the insurance limit to $250,000,

making up for the impact of inflation since 1980 when the $100,000 limit was set. It also gave the

FDIC responsibility for resolving large, systemically important banks, which broadens the agency's

mission dramatically beyond providing insurance to depositors.

Mortgage Loans

The Dodd-Frank Act dramatically impacts the willingness and ability of community banks to make

mortgage loans. It imposes broad risk retention requirements on most loans sold into the secondary

market and requires lenders to show that borrowers met an “ability to repay” test—which can be

challenged in court for the entire life of the loan, raising the risk of litigation tremendously.

Dodd-Frank provides exceptions to some of these requirements. The Qualified Mortgage (QM) is

intended to be a category of loans with characteristics that are deemed to meet the ability-to-repay

test. It is unclear if the QM will provide a safe harbor against legal challenge or only a “rebuttable

presumption,” which can be challenged in court. The Qualified Residential Mortgage (QRM)

provides exceptions to risk retention requirements. How these exceptions are defined is currently

being developed by the regulators.

Durbin Amendment

The Dodd-Frank Act's Durbin Amendment required the Federal Reserve to regulate debit

interchange fees and how transactions are routed from merchants to card issuers. The Fed's rule,

finalized June 2011, decreased interchange fees far below rates set by the marketplace. Rates are

now composed of a base fee of 21 cents per transaction and five basis points to cover fraud losses.

An interim rule would allow an additional one cent per transaction to cover fraud prevention efforts.

Price caps apply to all debit cards issued by banks with assets greater than $10 billion. The new rule also prohibits network exclusivity arrangements on debit cards, which allowed banks to negotiate more favorable terms.

Narrower Definition of Capital

Basel III defines regulatory capital more narrowly through explicit standards for Tier 1 common equity

capital. ABA expects the new definitions of capital to be applied to all U.S. banks.

Higher Capital Requirements

Certain types of bank assets will be subject to greatly increased capital requirements when the U.S.

adopts Basel III. These exposures include securitizations, trading assets, derivatives and exposures to

large banks. ABA is expecting some of these treatments to be applied to all U.S. banks.

Certain Banks Will Need to Hold Above the Minimum

Even while regulators are raising the minimum capital levels for all banks, ABA expects regulators to

continue to demand even higher capital levels at certain banks.

Source: American Bankers Association.

In the crossfire are Credit Unions, whose representatives say they will oppose the extension, one they say they don't need, unless rules are loosened to allow them greater access to business loans. The ICBA announced Monday it had collected more than 13,000 signatures on a petition that opposes legislation that would raise the current credit union member business lending cap from 12.25 percent to 27.5 percent of assets.

The Consumer Financial Protection Bureau, created by Dodd-Frank, is being watched closely by uneasy bankers. In a letter to the agency, the Credit Union National Association (CUNA) wrote that it needs to “fully understand and minimize the potential implementation and ongoing compliance costs and unintended consequences on credit unions from its potential new regulations.”

Andy Greenawalt, CEO of Continuity Control, a financial technology company, says his firm conducted analysis on the soundness of community banks and found that “amid the spectacular rise of regulations,” half of the nation's 7,000 community banks are barely surviving today.

These banks were forced to deal with 157 rule alerts issued in just the last year, 58 of which came down in the last six months. All together, 762 rule alerts were issued by the individual regulatory agencies over the last five years, with hundreds of subsequent updates. Greenawalt says the costs attached to the rise in regulatory requirements pushes the majority of community banks to a “compliance tipping point.”

“Without a dramatic improvement in efficiencies for handling regulatory compliance or a sudden drop in regulations, we could see 2,000 bank failures across the U.S. over the next few years,” he says.

 “It isn't going to stop, and it isn't going to stop for some good reasons and some bad reasons,” he says of the regulatory piling-on. “In the world of finite resources these community banks live in, the idea of putting more money into compliance is not how their business survives. It may be how they deal with Dodd- Frank, but it's not how their business survives.”

The worst-performing banks must move quickly to reengineer their operations with an eye toward efficiencies. “Greater compliance costs reduce net income, which is credit unions' only source of net worth. While increased compliance costs will not drive credit unions into immediate insolvency, it will reduce, on the margin, the protective cushion provided by capital, leaving credit unions less resilient during the next big financial shock,” Fecher told Congress.