THE EFFECTS OF REGULATORY COMPLIANCE FOR SMALL BANKS AROUND CRISIS‐BASED REGULATION

• DOI: http://doi.org/10.1111/jfir.12096
• Published date: 01 September 2016
• Date: 01 September 2016

THE EFFECTS OF REGULATORY COMPLIANCE FOR SMALL BANKS

AROUND CRISIS-BASED REGULATION

Ken B. Cyree

University of Mississippi

Abstract

In this article I investigate the regulatory burden for small U.S. banks around major

crisis-based regulatory programs using measures of profit, cost, and productivity from

1991 to 2014. After the passage of the Federal Deposit Insurance Corporation

Improvement Act, there is little evidence consistent with increased regulatory burden.

After the passage of the USA PATRIOT Act, the percentage change in employees

was positive, and average pay was higher for small banks. After the passage of the

Dodd–Frank Act, five of six regime-shift indicators were consistent with increased

regulatory burden, with lower pretax return on assets, lower loans per employee, lower

technology and fixed-asset expenditures, and higher percentage change in employees

and salaries-to-assets in panel regressions.

JEL Classification: G21, G28

I. Introduction

Bank regulation has been around for centuries and provides the positive effects of

reducing failure probabilities, increasing confidence in the banking system, and reducing

funding costs for insured deposits and other bank funding instruments. Regulatory

changes can also benefit banks in times of crisis. For example, banks benefited after the

2007–2008 financial crisis when the deposit insurance ceiling was raised, or they

received an injection of capital through programs such as the Troubled Asset Relief

Program-Capital Purchase Program. Additionally, after the 2008 crisis many bank

regulatory rules such as marking-to-market or deposit insurance assessments were

changed or suspended.

1

Bankers argue that regulatory burden significantly increases when regulation

and legislation is passed after a crisis. The 2014 KPMG Community Banking Survey

(Depman 2014) shows 32% choosing that the largest barrier to significant growth for

community banks is regulatory and legislative pressures. Furthermore, 45% of

I acknowledge the helpful comments of Allen Berger, Lucy Chernykh, and participants at the Southern

Finance Association meeting in Captiva Island, Florida. I also thank Larry Wall and Scott Hein for helpful

comments. In addition, I appreciate the discussions and comments from participants at the Federal Reserve/CSBS

Community Bank Research and Policy Conference in St. Louis. All errors and omissions are mine.

1

The deposit insurance costs noted on the Call Report and FR-Y9 are not available to the public. During and

after the 2008 crisis, deposit insurance premiums rose for banks, at least on average, even though this was not a

direct result of the Dodd–Frank Act.

The Journal of Financial Research Vol. XXXIX, No. 3 Pages 215–245 Fall 2016

215

© 2016 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

FINANCE ASSOCIATIONS BY WILEY-BLACKWELL PUBLISHING

community bankers indicate compliance costs are 5%–10% of total operating costs, and

33% of banks estimate compliance costs are 11%–20% of total operating costs. The

largest drivers of compliance costs reported are anti-money laundering (23%), consumer

protection (17%), and lending practices (17%). Clearly, bankers believe regulatory costs

are burdensome, yet there is relatively little study of compliance costs for banks and the

effect on loan production around new regulation.

Given the possible positive and negative effects of legislative changes on banks

after crises, the overall impact is an empirical question and is the focus of this study. I

estimate the effects of regulatory changes on small U.S. banks (defined as less than $5

billion in assets) around large crisis-based legislation from 1991 to 2014.

2

An additional

focus is whether small bank costs and loan production differ for major regulatory events

during crises compared to the most recent effects of the Dodd–Frank Act (hereafter

Dodd–Frank).

In large part, one reason this important area has not been studied is that a variable

that measures only the cost of complying with regulations does not exist in standard data

sources. For example, there is no field in the Call reports or FR-Y9 that indicates the total

dollar amount or time spent on complying with regulations or rules.

3

To properly

estimate the effects of regulatory burden of new regulations, data on direct and indirect

costs before and after the legislation are needed, and these data do not exist in standard

data sources. However, there are data on salaries, the number of employees, and the

dollar amount of bank loans from which at least a crude measure of compliance costs can

be estimated; it is these measures that are used in this investigation. If regulatory burden

increases around these events and is not offset in other ways, accounting performance

should fall and loan production decline. It could also be that banks pass along the

increased burden, if any, to customers in the form of higher prices. Thus, profits would

remain the same if banks can pass along the entire costs to borrowers. Other possible

effects of regulatory burden include an increase in the number of employees to handle the

new rules, an increase in average pay, a fall in technology expenditures if banks hire

compliance personnel and shift expenditures away from technology, or a rise in

technology expenditures if banks shift to technology to handle new rules and regulations.

The cost of compliance for banks is important to estimate so policy makers and

other stakeholders can evaluate whether the benefits from regulatory change are worth

the costs as discussed in LaFond and You (2010). In addition, regulations can have the

unintended consequences of weakening small banks if these costs are burdensome or

increase over time. Even though regulation can create valuable barriers to entry, lower

rates due to deposit insurance, and increased safety and soundness, costs of compliance

could make it uneconomic to continue operating a bank that would otherwise be viable.

2

In this article, small bank holding companies are used and are referred to as “banks”for easier exposition. I

refer to bank holding companies directly to highlight any differences that are present between the holding company

and individual banks when necessary.

3

The Consolidated Report of Condition and Income (commonly referred to as the Call report) is a regulatory

report for banks and the FR-Y9 report is for bank holding companies. The RI-E section of the Call report includes

expenses on data processing and legal/audit fees, but often these fields are missing for small banks, and even if they

are reported they are not a direct measure of the full costs of the regulatory burden.

216 The Journal of Financial Research