The Dodd–Frank Act has created significant challenges for financial institutions, especially for smaller community banks. The legislation was designed to promote the safety and soundness of America’s financial institutions, but some small banks are finding it a struggle to meet DFA’s additional regulatory requirements.

Here is a sample of DFA components presenting challenges to smaller banks:

• Risk Management – All banks have greater requirements to demonstrate investment in risk management infrastructure to measure and mitigate risk. Smaller banks have to spread these expenditures out over a smaller earnings base compared to larger institutions.

• Mortgage Lending – Lending to finance residential real estate purchases has long been a key community bank product. New requirements, including increased TIL, HMDA, and RESPA disclosures, limits on origination fees and compensation, and heightened requirements to meet Qualifying Mortgage standards all contribute to the cost of this line of business.

• Investment Grade Standard – Banks cannot rely exclusively on ratings from rating agencies to determine that an investment is a bank-eligible investment grade security. Instead, all banks (large and small) have to develop their own due diligence standards for credit-sensitive instruments such as municipal and corporate bonds. Many small banks don’t have the infrastructure or expertise to develop these capabilities in-house.

• Product Standardization – Many consumer-oriented products will be required to become more standardized. Smaller banks have typically created competitive advantages by developing specialized products that larger banks could not accommodate.

• Volcker Rule – Certain structured investments held by community banks could be considered “covered funds” under the Volcker Rule, requiring divestiture of these assets. Smaller banks are less likely to have the internal resources necessary to identify these securities, and some institutions have realized losses by divesting as an exercise of caution.

Rob McDonough

Dodd-Frank also established a $10 billion assets threshold that, once surpassed, designates a bank as a midsized institution. This requires them to comply with an additional set of regulations involving significant expenditures of time, effort, and money. Conversations with many banks, however, indicate that the pressure to comply with certain aspects of DFA starts well before reaching this threshold. Regulators are sending a message that banks under the threshold with moderate to aggressive plans for expansion through organic growth or acquisition need to demonstrate their ability to comply with enhanced compliance requirements well before taking such actions.

Many banks believe that the enhanced regulatory requirements associated with crossing the $10 billion threshold contain implicit penalties that discourage aggressive growth or acquisition.

Regulatory Burdens

The requirements of being categorized as a midsized institution are extensive. They include investments in new systems, hiring new compliance specialists, enhancements to existing risk management processes, and diverting current employees’ time and resources from traditional revenue-producing activities towards compliance.

Enhanced Dodd-Frank requirements add significant expenses to a bank’s existing cost structure. That only compounds the challenges banks face in an environment where low rates and uncertain economic conditions have already compressed margins and earnings.

These requirements include:

• The Durbin Amendment – The Federal Reserve is required to regulate debit interchange fees and how transactions are routed from merchants to card issuers. Price caps apply to all debit cards issued by banks with assets greater than $10 billion.

• Consumer Financial Protection Bureau (CFPB) – Compliance exams from the CFPB. The scope of the examinations will include:— Assessing controls detecting and preventing violations that may harm consumers.— Reviewing the products and services the institution offers, with a focus on risk to consumers.— Conducting fair lending reviews to detect and address potential discriminatory practices.

• DFAST – Required participation in an annual stress testing exercise to assess the impact of adverse and severely adverse scenarios on capital and liquidity. These exercises require sophisticated analytical and forecasting tools that are proportionately more burdensome to smaller banks from an overhead expense perspective.

A Rock and a Hard Place

The costs of meeting new compliance requirements is straining small banks’ expense structures, compressing the margins of traditional banking activities, and making it more difficult to compete. As a result, banks are making their products more vanilla since they are discouraged from developing innovative products and services. They are hiding in the safety zone to avoid attracting regulatory attention, further reducing the value of their franchise.

And franchise value is exactly what banks need in this environment. As increased regulatory burdens lead small banks to reconsider their product line and service offerings, some are considering exiting tradition banking activities. Others are contemplating exiting banking altogether by putting their institutions up for sale. Dodd-Frank is fueling bank consolidation as some smaller institutions grasp for ways to extract value from their franchises.

Unfortunately, the very regulations that are driving banks to consolidate are also diminishing their core value as they become less profitable. There simply aren’t many exit strategies when earnings are constrained in a time of higher capital requirements. Community banks are stuck between a rock and a hard place.

Dodd-Frank will continue to be a speed bump for small banks looking to expand their business and grow beyond the $10 billion threshold. If community banks want to grow and be successful, they’ll need to take a step back and form a strategic plan to navigate and satisfy the regulatory burdens that come about when approaching this mark. Small banks must evaluate a variety of alternatives that could help them continue to remain competitive in this environment and ensure a successful path to preserving the franchise’s value.

Rob McDonough is a senior consulting manager for Angel Oak Consulting Group, a risk management consultancy to depository financial institutions, investment firms, and regulators. He previously spent 12 years as an economic analyst and capital markets examiner with the Federal Reserve System.