The agreement reached between Senate Banking Committee Chairman Mike Crapo and ten Senate Democrats is billed as a necessary technical fix to Dodd-Frank and regulatory relief for community banks. But this proposal would cause more harm than many—including some allies—currently believe. It would expose risk to mid-sized banks, threaten the stability of the financial industry, and, in turn, put consumers and the broader economy in harms way. While yesterday’s introduction of this legislation gained little public attention—there are a dizzying number of big reforms moving in Congress, i.e., tax reform—there is good reason to pay attention and oppose Senator Crapo’s proposal.
Crapo’s proposal will expose consumers and the economy to serious risks from large, regional banks with up to $250 billion in assets—like SunTrusts, Fifth Third, State Street, and American Express—by preventing supervision by the Federal Reserve.
The cornerstone of this proposal is to raise the systemically financial important institution (SIFI) threshold for bank holding companies from $50 billion to $250 billion in asset size, which triggers enhanced safety and soundness standards, including higher capital requirements and oversight from the Federal Reserve. The proposal exempts banks between $50 and $100 billion in asset size from enhanced safety and soundness standards and Federal Reserve oversight, and gives the Federal Reserve regulatory discretion for banks with between $100 and $250 billion in assets.
Moving the threshold to $250 billion would free up 27 banks—many of which are large institutions, like American Express, SunTrust, and BB&T—from the kinds of supervision and regulations that are needed to prevent harm to consumers and the economy at large. Some have made a case for decreasing the threshold to $100 billion, but the $250 billion is much higher than earlier proposals. In fact, Treasury Secretary Steven Munchin proposed the $250 threshold earlier this year—hardly a compromise.
Recent history shows that shocks to small and mid-sized banks can cause significant harm to the economy and consumers. While many regulators and policymakers focus on the largest players since the 2007-2008 Financial Crisis, we shouldn’t forget the savings and loan (S&L) crisis in the 1980s and 1990s, which showed that smaller and mid-sized firms can and do pose just as much risk. More than 1,000 (over one-third) S&Ls failed by 1989, which posed significant damage on the mortgage industry and ended one of the most secure sources of home mortgages for consumers. In fact, taken together, the small and mid-sized banks that would be largely exempted from scrutiny under the bill have $3.8 trillion in assets and represent 20 percent of all banking assets. If a shock hit these banks in aggregate, it would have serious repercussions across the financial industry and impact many consumers.
Without an explicit mandate, the Federal Reserve is likely to do nothing to account for the risk by larger banks in the $100 to $250 billion threshold. Without proper instructions, the Fed will be prone to cronyism and preferential treatment of banks in the $100 billion to $250 billion range. In Dodd-Frank, Congress gave regulators specific goal posts and guardrails when constructing the specifics of capital requirements. There were floors and ceilings and requirements that guided regulators into how to build the system that was put into place. Congress took steps in Dodd-Frank to require the Fed to take action, and, absent such a requirement, the Fed is unlikely to act.
Graphic source: Davis Polk
Crapo’s proposal claims to “right size” Dodd-Frank regulations for mid-sized and small banks, but Dodd-Frank already accounts for size and risk through a tiered approach that mitigates risk and protects consumers across the entire financial system. Dodd-Frank introduced three notable regulations for banks over $50 billion in consolidated assets: stress tests, liquidity requirements, and living wills. As the graphic above shows, firms between $50 billion and $250 billion in asset size are subject to miniature versions of these requirements that are significantly less strict than those for larger firms.
Policymakers—including Senator Crapo—talk about “right sizing”—i.e., making the regulations appropriate to the size of the firm. As you can see, Dodd-Frank already accounts for this. These light, less strict versions of regulations are important for mitigating systemic risk. For example, firms don’t naturally think of the damage they would case if they fail, but the living will process forces them to consider and prioritize planning for a possible failure. Liquidity has consistently tripped up the financial sector, and a light version of the liquidity coverage ratio (LCR) prioritizes establishing appropriate liquidity standards. Stress tests push risk management to think about the worse case scenarios outside hitting predefined metrics. These are important for the health of the banking sector, even for banks with $50 billion in assets, and increasing the threshold to $250 billion breaks the overall integration of these practices.
Community banks received ample relief. Crapo’s proposal to undermine Dodd-Frank protections for community banks are unnecessary, will lead to risky activities, and could result in bank consolidation that will hurt consumers.
The proposal exempts community banks—banks and credit unions with $10 billion or less in consolidated assets—from a series of Dodd-Frank rules that are important because they ensure these banks are serving consumers and are engaged in safe and appropriate financial activities. Community banks largely serve counties that are the least populated non-metropolitan and rural areas that typically suffer from economic divestment and underemployment. They are the only source of banking services that foster real economic growth and job creation, so it is crucial that these banks aren’t engaged in predatory or excessively risky activities.
The deal puts in place a series of deregulatory measures, which let community banks off the hook for safety and soundness standards and permit risky behavior, like proprietary trading. The proposal enables an off-ramp from certain capital and leverage requirements by establishing a community bank leverage ratio between 8 percent and 10 percent. Banks and credit unions with less than $10 billion of assets that meet the ratio would be considered in compliance, and thus, off the hook for further capital and leverage requirements. The proposal also provides banks with less than $10 billion in assets relief from mortgage lending rules, including the qualified mortgage rule and the Volcker Rule, which prevent banks from proprietary trading.
Despite the industry’s claims for needed relief, community banks are highly profitable, which undermines claims that Dodd-Frank is unworkable and causing banks to struggle. The most recent report from the Federal Deposit Insurance Corporation (FDIC) showed that community banks’ net income rose 8.5 percent from last year. The previous quarter, community bank profitability was up 10.4 percent. The FDIC’s 2016 quarterly profile on FDIC-insured banks found that community bank revenue and loan growth outpaced the industry at large. Since Dodd-Frank was passed in 2010, aggregate profit of FDIC-insured banks, including community banks, has followed an upward trajectory. The same FDIC report found that the annual loan growth rate at community banks outpaces that of non-community banks. Loan balances for community banks rose by 7.7 percent over the past 12 months. This is more than twice the loan growth in large banks, which was 3.3 percent. Over 75 percent of community banks increased their loan balances from a year ago. The fact is, community banks aren’t struggling the way many policymakers and industry advocates describe, meaning the rules have been “right-sized” from the beginning.
Ample exemptions for community banks were already baked in Dodd-Frank, making these additional exemptions unnecessary. A range of exemptions was in put in place to protect community banks in Dodd-Frank. As the Congressional Research Service found, 13 out of 14 of the most important Dodd-Frank rules relating to banks “either include an exemption for small banks or are tailored to reduce the cost for small banks to comply,” and include greater underwriting flexibility when issuing mortgages and exemption from enhanced prudential regulations. These new thresholds will not help them thrive and compete.
Beyond the exemptions for community banks in Dodd-Frank, Congress recently passed additional relief and exemptions from prudent examinations and regulations. The Crapo bill triples the asset threshold for Small Bank Holding Company Policy Statement from $1 billion to $3 billion, which allows these banks to operate with higher levels of debt than would normally be permitted. It moves the threshold for an 18-month examination cycle from $1 billion to $3 billion. In December of 2014, Congress moved the Small Bank Holding Company Policy Statement from $500 million to $1 billion, and they extended the 18-month examination cycle threshold from $500 million to $1 billion as part of the FAST Act funding highways in December of 2015. These relief proposals were a long-time ask of community banks, but clearly they continue to push for more even after getting what they asked for from Congress three years ago.
Tripling the threshold after it was doubled only three years ago is imprudent, especially since the first extension has yet to be analyzed to identify the impact on the industry, consumers, and the overall economy. This is a six-fold increase done quickly and behind doors, and it indicates that this is less about tailoring rules for community banks and more about community banks pushing for anything they can get.
This deal could increase consolidation among community banks, making it harder—not easier—for consumers to get the services they need. The number of banks in the U.S. has decreased for decades because of the deregulation of interstate banking. The Financial Crisis also led to an increase in community bank failures and market concentration, especially among banks engaged in riskier, and often predatory, mortgage lending. Despite these factors, the FDIC found that most community banks remained resilient amid long-term industry consolidation, and the trend of consolidation has largely been confined to banks with under $100 million in assets from 1985 to 2013. During this period, the number of institutions with assets under $100 million declined by 85 percent, while the number and total asset size of banks with $100 million to $10 billion in assets increased by over 5 percent. The higher thresholds will likely lead to more consolidation by making it more profitable and enticing for banks to merge up to the $250 billion threshold.
The Crapo proposal leads us in the wrong direction on a critical component of the safety and soundness of banks: leverage requirements.
We should be strengthening, not weakening the leverage ratio to provide extra buffer for capital requirements. This bill would allow a handful of custodial banks to remove central bank funds from their assets for calculating the supplemental leverage ratio. This is a step in the wrong direction, and if it goes further, it would significantly undermine the strengths of the leverage ratio. There are some who feel that the leverage ratio is redundant alongside risk-weighted capital requirements. However, those requirements have no ability to provide a level of security for asset-wide downgrades, and they remain too reliant on ratings agencies that have serious conflicts. As outgoing FDIC Chair Martin Gruenberg notes, if these efforts go further they would cut the leverage ratio by 25 to 50 percent.
What’s noteworthy is that these predominantly deregulatory efforts are touted as simple technical fixes that will enable community banks to thrive, but they will likely have a larger impact on the structure, safety, and soundness of our financial sector. Most notably, small and mid-sized banks will have more of an incentive to consolidate, creating bigger mid-sized firms.
Will the bill “improve our financial regulatory framework and foster economic growth,” as Senator Crapo and other co-sponsors claim? It’s unlikely. We hope other policymakers and allies will follow Senate Banking Ranking Member Sherrod Brown and Senator Elizabeth Warren in recognizing that this bill isn’t good for consumers and the financial health of our economy.
 See “Winners and losers of Senate reg relief bill,” November 4, 2017. American Banker.
Also published on Medium.