House Small Business Subcommittee on Investigations, Oversight and Regulations Hearing
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Chairman Schweikert, Ranking Member Clarke, and members of the Subcommittee, thank you for the opportunity to be part of today's hearing on regulatory burdens on small financial institutions. n1
In financial services, as in every other sector,
Increasingly burdensome regulation is not the only challenge facing small banks and credit unions. They are also confront-ing slow economic growth, declining populations in rural areas, the increasing technological sophistication of banking, the sustained low-interest-rate environment, competition from new types of financial services providers, and difficult capital markets. Small financial institutions can adapt and excel in the face of such challenges, but not if regulation stands in the way and absorbs resources and managerial attention that would otherwise be devoted to dealing with them.
Today I will briefly discuss the importance of small financial institutions and then talk about three ways in which regulation or regulators are threatening their future prospects. First, the regulatory framework accommodates large financial institutions better than it does small ones. Second, the increased regulatory and compliance burden is felt most heavily by the smallest financial institutions. Finally, regulators' lackluster commitment to fundamental administrative process protections takes a particular toll on small financial institutions.
THE IMPORTANCE OF SMALL FINANCIAL INSTITUTIONS
With one-fifth of one percent of the banking industry controlling two-thirds of its assets, n2 it is easy to forget the important role that the remaining financial institutions--most of which are small--play. Many have served their communities for decades and continue to serve the financial needs of millions of retail customers and small busi-nesses. Community banks are particularly important in rural areas. The
Community-based financial institutions are able to distinguish themselves from larger competitors by develop-ing firsthand knowledge about their customers. This enables them to provide personalized service and meet the needs of the local residents and businesses in ways that a larger, nonlocal bank, which does not know the unique characteristics of the community, cannot. The
Despite the decline in their number, community banks and credit unions have maintained their relation-ship-banking model, relying on their relationships with customers and local knowledge to make loans. Such institutions can use their relationship-based information to make loans to small businesses and other borrowers that larger banks may not make because of their general reliance on more automated processes. n8
Federal Reserve Governor
Firsthand knowledge of customers provides useful information for making sound lending decisions. Credit unions report that delinquent loans peaked in 2009 at 1.82 percent of credit unions' loan portfolios and were down to 1.15 percent at the end of 2012. n10 Community banks' loans tend to default at lower rates than loans made by bigger institutions. The rate of loans in default for the first quarter of 2013 on loans secured by residential properties was 3.47 percent for banks with less than
REGULATORY FRAMEWORK IS DESIGNED FOR LARGE FINANCIAL INSTITUTIONS
The regulatory framework is not well suited to the kind of lending that distinguishes small financial institutions from their large bank counterparts. n14 A recent survey of community bankers found that "many bankers felt that the move toward standardized products and a 'one-size-fits-all' supervisory approach were taking away one of the strongest advantages of community banks: the ability to tailor products to fit individualized needs." n15
A prime example of this is Dodd-Frank's approach to consumer financial protection that allows the new
A recurring theme in Dodd-Frank . . . is that the standardization of financial products and forms will protect con-sumers. This is implicitly a reaction to the narrative that one of the causes of the financial crisis was the inability of parties to understand and appreciate the risks of innovative financial products. But the focus on standardization of consumer financial products, like home loans and checking accounts, fails to recognize the value to consum-ers of the community banking model, which emphasizes relationship banking, personalized underwriting, and customization of financial products to meet the specific needs of customers and communities. n16
While the needs of homogenous consumers can be met with homogenous products, the fundamental assumption that consumers are homogenous is wrong. Community-based financial institutions' practice of getting to know their customers and tailoring products to their needs is at odds with the Dodd-Frank version of one-size-fits-all consumer protection.
Rules adopted by the
As one example, the new qualified mortgage rules specify parameters for mortgages that satisfy Dodd-Frank's ability-to-repay requirement. Nonqualified mortgages can be offered, but the associated legal risk is high. The
A recent survey of credit unions found that sixty percent will "discontinue, delay or reduce their mortgage loan product offerings" because of
If community banks and credit unions are unduly constrained in their ability to offer traditional products and ser-vices, they may feel pushed to go into lines of business with which they are not familiar. This could pose a risk to the viability of the banks, credit unions, and ultimately to the government deposit insurance funds that back them. The
Regulations are often written with big financial institutions in mind. The Basel III capital rules are one such example. As the
Regulations explicitly crafted to preserve large financial institutions--such as systemic designations under Title I of Dodd-Frank--can have a deleterious effect on small financial institutions. These kinds of regula-tions lead to market perceptions that regulators will not let large financial firms fail. Institutions that are perceived to be too big to fail enjoy a subsidy, n28 the size of which and degree to which it is offset by increased regulatory costs are hotly debated. n29 Although not typically competing directly with designated financial companies in the capital markets, n30 small banks are at a funding disadvantage, particularly in a time of wide-spread crisis, when banks are most likely to need to raise money to survive. Large banks that enjoy explicit or implicit government backing will find it a lot easier to attract private capital than community banks. Large banks with a systemic designation are also likely to find it easier than other financial institutions to obtain and retain customers, for whom the government's designation functions as a perceived guarantee of the financial institution's longevity.
INCREASED REGULATORY BURDEN FALLS MOST HEAVILY ON SMALL FINANCIAL INSTITUTIONS
Contrary to a popular misconception, the financial services industry is not lightly regulated and was not prior to the crisis, either. n31 Regulatory costs imposed on financial institutions are passed on, in whole or in part, to the cus-tomers that rely on these institutions. The increasing burden of regulations is a reality across the entire financial industry. n32 It falls disproportionately on small financial institutions. n33 Indeed, regulatory burdens have been and are likely to be the death-knell of many of the smallest financial institutions.
With respect to regulatory compliance, small financial institutions are at a clear disadvantage. They cannot spread costs over a large portfolio of loans. They do not have their larger competitors' sophisticated legal and compli-ance staffs to interpret the new rules and regulations and look for effective ways to comply with those regulations without compromising their ability to serve customers and earn profits. Regulators have made some attempts to ease the burden by, for example, organizing dialogues with community banks and preparing compliance guides for community banks. n34 Nevertheless, regulation ends up giving larger financial institutions a competitive advan-tage over smaller ones. n35
Regulations have built up over time, and it is difficult to pare them back. n36 As one community banker recently explained to
As a Federal Reserve staff study of the costs of bank regulation explains, "Higher average regulatory costs at low levels of output may inhibit the entry of new firms into banking or may stimulate consolidation of the industry into fewer, large banks." n39 A more recent effort by the Federal Reserve Bank of
Small banks often supplement internal compliance staff with compliance advice from outside consultants and software providers. Community bankers with whom the
In addition to the costs of hiring new compliance personnel and buying new software, there are less easily quantifiable compliance costs, including "psychological costs" and "dynamic changes in the risk-taking of banks" to compensate for "higher fixed costs." n43 When confronted with too many regulations, managers can lose their ability to focus on serving customers in a profitable and sustainable manner. Regulatory burdens and worries divert time and resources away from the day-to-day business. If the distraction is severe enough, there will be an increased likelihood of financial institution failures, which is a matter of concern to bank shareholders, employees, and customers, and to American taxpayers, who may ultimately be asked to pick up the tab for failed banks and credit unions.
Even when
New rules under Dodd-Frank aggravated the already heavy regulatory burden. In a 2012 survey of
INADEQUATE REGULATORY PROCEDURES
Regulators have not given sufficient consideration to the costs that regulations impose on small financial institu-tions. Small financial institutions are less likely than bigger institutions to have policy-related interactions with their regulators. n48 Regulators are making some efforts to learn about issues that affect small banks and credit unions, n49 but they can do more.
Agencies have been faulted for not adequately fulfilling their responsibilities under the Small Business Regulatory Enforcement and Fairness Act of 1996 (SBREFA). The Federal Reserve's Inspector General issued a report several months ago that found that the Federal Reserve was not providing consistent, clear, and useful small entity compli-ance guides and that it could "considerably improve its approach to ensure that its compliance guides consistently (1) explain the actions a small entity should take to comply with the corresponding final rules and (2) enable a small entity to know when such requirements have been satisfied." n50 The Federal Reserve's inspector general cur-rently is conducting an evaluation of the
Regulators have thus far resisted taking a more fundamental step towards understanding the implications of their regulations. Because the federal financial regulators are independent regulatory agencies, they are not subject to executive orders that require executive agencies to conduct economic analysis. n53 Even absent a requirement, however, the federal financial regulators should perform economic analysis of their own volition. It is a tool that would help them identify both the problems they are trying to solve and effective solutions that do not unduly burden financial institutions and the consumers they serve. Yet the regulators have consistently failed to conduct the kind of economic analysis that would help to elucidate unintended consequences before a new regulatory burden is imposed. n54 A
I also do not believe we should write a report on the cost-benefit analysis of every regulation NCUA pro-poses. Doing so would be too burdensome, or necessitate hiring additional employees. In any event, the intended benefits are generally obvious in the regulations we propose, and, indeed, many comments point out potential costs-we need not duplicate those efforts. Like credit unions themselves, we at NCUA need to run as tight and as focused an agency as we can. n55
While performing rigorous economic analysis is not easy, it is preferable to regulating without a complete analysis of the costs and benefits. A statutory requirement that all rulemaking by the financial regulators be informed by economic analysis could assist the regulators in designing better regulations and identifying instances in which additional regulation is not necessary. This, in turn, would help to stop unnecessary regulatory burdens from being placed on small financial institutions.
CONCLUSION
Small banks and credit unions face a growing list of regulatory obligations. The discouraging reality is that many of these regulations are not working to make banks safer or to protect consumers. They are absorbing more and more of small financial institutions' time, talent, and other resources. They are preventing small financial insti-tutions from effectively and safely playing their essential role in the financial system. Once the Mercatus Center has finalized the results of our small bank survey, we expect to have a better understanding of the nature of the challenges small financial institutions are facing and the opportunities they are seeing in the current environment. These results should help policymakers to better understand how they can ensure that the American banks and credit unions remain vibrant, competitive, efficient, and customer-focused.
Thank you again for including me in today's discussion. I would be happy to take any questions.
n1. The definition of "small financial institution" is open to debate. I favor a cutoff of
n2. Hearing on "Examining How the Dodd-Frank Act Could Result in More Taxpayer-Funded Bailouts," Before the
n3. See
n4.
n5.
n6.
n7. Schenk, "Commercial Banks and Credit Unions," 9-10,
n8.
n9.
. Schenk, "Commercial Banks and Credit Unions," 11.
n11. See FDIC Statistics on Depository Institutions, accessed
n12. See, e.g.,
n13.
n14. Even some well-intentioned regulatory changes may have the effect of decreasing small financial institutions' reliance on soft information. See, e.g.,
n15.
n16. Marsh and Norman, Impact of Dodd-Frank, 39.
n17. Walter, "Not Your Father's
n18. Marsh and Norman, "Impact of Dodd-Frank," 11.
n19.
n20.
n21.
n22.
n23. Hearing on the State of Community Banking in the Current Regulatory Environment, Before the Subcommittee on Financial Institutions and Consumer Credit of the
n24. High
n25. For a discussion of comments related to community banks, see Revised Memorandum from Staff to
n26.
n27. See, e.g.,
n28. See, e.g.,
n29. For a spirited sample of that debate, compare
n30. For a discussion of community bank capital-raising practices, see
n31. See, e.g.,
n32.
n33.
n34. See, e.g.,
n35. Many of the community bankers participating in a survey in the early 2000s "voiced strong concerns that the rules of competition worked against them--namely, that state and federal regulation placed them at a disadvantage relative to their large bank and nonbank rivals."
n36. This problem is not limited to the banking industry. See, e.g.,
n37. Hearing on "Examining Community Bank Regulatory Burdens," Before the Subcommittee of Financial Institutions and Consumer Credit of the
n38. Regulatory Burdens: The Impact of Dodd-Frank on Community Banking, Hearing before the Subcommittee on Economic Growth,
n39.
n40.
n41. Community Banking Hearing, 67 (letter of
n42.
n43.
n44. TXuan (
n45. Ibid., 2.
n46.
n47. Ibid., 10.
n48. Nearly thirty-five percent of the respondents in our survey had been contacted by a regulator regarding the feasibility of Dodd-Frank imple-mentation, but most of the contacts came from state regulators.
n49.
n50.
n51.
n52. See, e.g., Letter from Various Small Business Organizations to
n53.
n54. For a more in-depth discussion of this topic, see
n55.
Read this original document at: http://smbiz.house.gov/UploadedFiles/12-3-2013_Peirce_BurdensOnSmallBanks_testimony_112613.pdf
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