1.25.2015 Dodd-Frank: Impact on Community Banks

It has been more than five years since the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law. When the law first passed, many in the banking industry voiced concerns about the impact it might have on community banks, which are disproportionately affected by the legislation due to their smaller size.

Especially concerning was the higher capital and equity requirements Dodd-Frank placed on community banks. In addition, the law places a greater regulatory burden on community banks via new disclosure and reporting requirements, provisions and obligations. It’s true that all banks are subject to these regulatory requirements; however, their costs will likely have a disproportionate impact on smaller community banks than on large banks with greater economies of scale.

Finally, Dodd-Frank limits how much money banks can charge merchants in interchange fees, which is lowering non-interest fee income. While banks with less than $10 billion in assets are exempted from this provision of the law, the reality is that many community banks are being forced to lower their interchange fees to remain competitive. And it doesn’t help that regulatory guidelines have placed limits on how much banks can charge customers in NSF fees.

Doing the Math

When you do the math, it’s clear that Dodd-Frank is making it harder for community banks to earn the same profits they did in the past. Higher capital and equity requirements, lower fee income and higher compliance costs all add up to lower return on equity (ROE) for community banks.

Given the higher levels of capital required by the law, community banks must earn more money on every dollar of revenue generated in order for ROE to hold steady. In this scenario, the bank has to increase its return on assets (ROA).

Traditionally, community banks have generated interest income and driven revenue by making residential mortgages and construction, commercial real estate, and acquisition and development loans. But regulatory caps on commercial real estate and construction loans as a percentage of capital are reducing the amount of interest income many community banks are earning from these types of loans.

And more stringent mortgage lending rules are forcing some community banks to shy away from this type of lending. In the American Bankers Association 2014 Real Estate Lending Survey Report, more than a third (38 percent) of banks said the new Dodd-Frank mortgage regulations caused them to reconsider their commitments to mortgage lending.

Interest expense, meanwhile, is rising, thanks to new reporting and disclosure requirements, new non-discrimination lending rules and higher compliance costs. And non-interest fee income is falling, as noted above.

Add It All Up

Add all of these factors up and it’s clear that earning a profit is harder for community banks in the post-Dodd-Frank world than it was before financial reform was signed into law. Some industry experts and observers believe that the eventual result will be a consolidation of community banks as they merge with each other or are acquired by larger banks.

The Dodd-Frank Act contains nearly 400 new banking regulations that will eventually be drafted and enacted, but only about half of them have been implemented so far. So it will likely be years before the full impact of the law on community banks is felt.

In the meantime, community banks will continue to await the final drafting and implementation of all the rules contained in Dodd-Frank’s nearly 5,000 pages of regulations. This makes now a good time for community banks to strategize how they can boost profitability in today’s challenging environment — or start thinking about whether a merger or acquisition might eventually make more sense.