This summer marks the ninth anniversary of the Dodd-Frank Wall Street Reform and Consumer Protection Act. At more than 360,000 words and 2,300 pages in length, the Dodd-Frank Act represents the “longest and most complex piece of financial regulation in American history.”
Has Dodd-Frank achieved its goal of making the U.S. financial system safer and more resilient? And what impact has the wave of new rules and regulations that were passed in its wake had on bank lending and the overall health of the economy?
The jury is still out on whether the bill has made the financial system more robust to the next crisis. But we are starting to get a clearer picture of what impact it has had on compliance cost, bank lending, and bank consolidation.
One of the biggest debates has focused on how heavy of a regulatory burden the act has imposed on banks. In the immediate aftermath of its passage, banks complained that the bill had imposed significant costs on their operations. A 2012 survey by the American Bankers Association (ABA) found that the act imposed “daunting new compliance, operational, and recordkeeping burdens” on the banking system.
Although the act was designed to target larger banks that were deemed “too big to fail” (or “systemically important financial institutions”), one of the key findings in many early surveys was that the act’s costs were being disproportionately borne by smaller banks. This is significant because smaller banks often lack the legal and administrative resources of larger banks to comply with an onslaught of new rules and reporting requirements.
In 2012, William Grant, chairman of the Community Bankers Council of the ABA, testified before Congress that the act raised compliance costs for smaller banks by “$50 billion annually, or about 12 percent of total bank operating costs.” In a 2014 survey of more than 200 community banks, Peirce, Robinson, and Stratmann found that “more than 80 percent of respondents saw their compliance costs rise by more than five percent” since 2010.
A landmark report by Lux and Greene (2015) found that the rate of decline in community banks’ market share of U.S. commercial bank assets doubled after the passage of Dodd-Frank. The heavier regulatory burden also accelerated bank mergers and consolidations since small banks lacked the resources to keep up with new regulations. This contributed to the sharp decline in new bank entry, which fell from on average 100 new entrants per year to only 3 since 2010. It also contributed to the sharp decline in the share of small-business loans by banks since 2010.
Despite these claims by bankers, two prominent studies often cited by financial regulators found little evidence that Dodd-Frank had any discernible impact on bank costs or profitability. In their 2014 article for the Federal Reserve Bank of Richmond, McCord and Prescott concluded that the increase in bank expenses was “relatively small and, more importantly … too small to have a big effect on bank profitability” (42). A 2015 GAO report went even further, arguing that noninterest expenses had decreased or remained flat since the third quarter of 2010 (39).
What explains this big gap between what bankers and financial regulators say about whether Dodd-Frank has significantly increased bank costs? In an article published this month in the Journal of Regulatory Economics, Thomas Hogan and I expand on these studies in three ways.
First, since many of the regulations pursuant to Dodd-Frank (particularly those that affect small-bank lending) were spread out in the years after the bill was passed, we test whether a one-time jump in bank expenses occurred right after Dodd-Frank’s passage or the increases in expenses were more closely related to increases in regulations implemented in the years after the act was passed. Our regression analysis also accounts for the significant secular decline in noninterest expenses that began long before the financial crisis to give a more accurate idea of what bank expenses might be relative to their total assets in the absence of Dodd-Frank.
Second, since most studies looked broadly at trends on noninterest expenses, we break down these expenses into four specific subcategories to get a more precise idea of changes in specific types of spending over time: legal, consulting, auditing, and data processing. We also consider the differences between salary-related expenses and other types of expenses that might be more closely related to regulations. Disaggregating the data in this way helps us address a key concern raised by bankers that rises in compliance-related expenses were often masked by cuts in other areas. Given the hypercompetitive nature of the banking sector and narrow profit margin most small banks operate with, it makes sense that banks might have to cut noninterest expenses in some areas to help pay for higher regulatory costs.
Finally, we break down our sample into large and small banks to compare the effects of Dodd-Frank regulations on banks of different size.
Our results largely confirm bankers’ claims that Dodd-Frank has imposed significantly higher compliance costs on banks of all sizes. Our baseline estimate is that noninterest expenses are $65 billion higher per year relative to their pre–Dodd-Frank trend, with estimates ranging from $59 billion to $86 billion. If anything, these are likely low-ball estimates. It is almost impossible to fully account for the costs of reallocating workers and resources out of productive business activities and into compliance-related activities — a common practice at smaller banks.
What does all this mean? It’s not surprising that the largest financial-reform bill in U.S. history has imposed considerable costs on banks. The question policy makers should ask is: what are we getting in return for these higher costs? Is our financial system really safer?
It’s not clear that Dodd-Frank has done much to fortify the financial system. If anything, it might have had precisely the opposite effect, particularly with respective to ending “too big to fail.” Evidence also suggests its new reporting requirements have suppressed small-business lending, particularly among small and mid-sized banks that specialize in this sort of lending. This helps explain why the recovery in bank lending was so weak after the Great Recession.
As we approach its nine-year anniversary, the Dodd-Frank Act appears to be here to stay. But the debate over its merits, effectiveness, and unintended consequences should be far from over.