Tougher bank regulations have unintended consequences

Regulatory requirements tied to bright-line thresholds are particularly prevalent in banking regulation. When a bank exceeds a threshold, usually in terms of total assets, it becomes subject to several regulatory requirements.

The most recent example of this involves some of the requirements outlined by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).

{mosads}In particular, banks with total assets exceeding $10 billion are subject to company-run stress testing, to oversight by the Consumer Financial Protection Bureau (CFPB) and to restrictions on the extent of debit card interchange fees that banks can charge.

The new requirements significantly increase regulatory costs, which can alter the growth decisions of banks surrounding the threshold.

In particular, the large increase in regulatory costs may incentivize banks to engage in an acquisition. This follows because financial statement ratios will be negatively affected upon crossing the threshold, leading bank managers to search for ways to partially offset this negative effect.

Acquisitions are an attractive strategy given that many of the costs associated with the new regulatory requirements are fixed in nature. Therefore, a bank that grows larger will be able to spread the regulatory costs over a larger asset base and better offset the negative effect on financial statement ratios.

There are a few examples of banks engaging in an acquisition as they approach or cross the $10-billion threshold, but the pervasiveness of this behavior has not previously been documented.

In my recent paper, “Regulatory Asset Thresholds and Acquisition Activity in the Banking Industry” with Hailey Ballew (Ohio State University) and Michael Iselin (University of Minnesota), we examine how acquisition activity changes for banks surrounding the $10-billion threshold, both those approaching the threshold and those that are just above the threshold, following Dodd-Frank.

We document that banks surrounding the $10-billion threshold engage in more acquisitions following the announcement of Dodd-Frank. We also show that banks surrounding the $10-billion threshold pay more for target banks and acquire relatively larger targets.

Collectively, this suggests that banks surrounding the $10-billion threshold increase demand for acquisitions following the announcement of additional regulatory requirements in Dodd-Frank. It also indicates that banks surrounding the threshold are acquiring relatively larger target banks in an effort to grow more quickly.

Another potential avenue that banks may consider is trying to remain below the threshold so they may avoid the regulations, at least in the near term. Banks primarily use deposits to fund asset growth, which indicates that if banks want to slow their asset growth, they need to slow the inflow of deposits.

We find that banks just below the $10-billion threshold appear to reduce their demand for deposits by slowing their deposit growth rate and by lowering the interest rate that they pay for deposits. This indicates that in addition to motivating some banks to grow quickly via acquisition when approaching and just above the threshold, regulations with asset thresholds may motivate other banks to slow their growth rate in an effort to avoid the regulatory costs.

The implication of our findings is that regulatory requirements may affect growth decisions made by banks, which is an unintended consequence of the regulations. Moreover, our findings suggest that asset thresholds in regulation may contribute to consolidation in the banking industry.

This is of particular interest given concerns with consolidation of both large banks at the top of the industry and smaller banks at the bottom of the industry. Our paper suggests that regulations may contribute to the disappearance of community banks, which may serve important segments in the United States.

Collectively, the results of our study should be of interest to bank regulators as they evaluate current regulations and implement new regulations using asset thresholds to apply regulatory requirements.

Allison Nicoletti is an assistant professor of accounting at the Wharton School, University of Pennsylvania.