INSIGHT: In a regulatory era, small U.S. banks are getting some relief

September 8, 2016

(Thomson Reuters Regulatory Intelligence) – While the regulatory pendulum has swung toward the “more” side since since the advent of Dodd-Frank Act in 2010, a relatively new – and less noticeable — counter-trend has emerged toward addressing complaints by smaller banks of disproportionately heavy regulation.


The Independent Community Bankers of America (ICBA), an organization representing locally owned and operated banks in the United States, including many small banks, has argued that regulatory and paperwork requirements impose a disproportionate burden on its members. The burdens reduce their ability to attract capital, support their customers’ credit needs, and ultimately make a profit.

Small bankers have complained about two regulatory areas in particular — “qualified mortgages” that meet abilty-to-pay standards and capital standards.

“The rules on the qualified mortgage, and regulations on risk weight component of Basel III capital standards applicable for commercial real estate loans are considered to be the two most challenging regulatory areas by community bankers,” said Christopher Cole, executive vice president and senior regulatory counsel at ICBA in an interview with Thomson Reuters.

On the qualified mortgage, or QM, rule, banks must face rigorous standards of proof to demonstrate that the loan is not risky. These include documentation of the borrowers’ ability to repay and of the mortgages’ contract structures (such as balloon payments) confirming that there no nonstandard clauses. In other words, regulators have put the onus on the banks from the onset to prove that the loans conform with the QM rule.

The upshot is that the information required to document for each CRE loan’s conformity with the QM may come out to be more costly than the information that the banks routinely collect as part of their own traditional due diligence and monitoring efforts.

Regulatory cost studies have found that the QM rule affects a significant share of mortgage lending by small banks. Such lending represents about 22 percent of total loan portfolio for banks with less than $100 million in assets.

As for the Basel risk-weights, the 50 percent increase from previous Basel risk-weight levels to the current 150 percent risk weight for the particular class of commercial real estate loans known as ‘high-volatility CRE’ have the potential to hit the small banks hard, as most small banks invest relatively heavily in commercial real estate. Indeed, the CRE loans comprise about 50 percent of small bank loan portfolios.


Despite these concerns, however, there is little evidence – with the notable exception of the high-risk mortgage products– of banks discontinuing any of their services or products as a direct consequence of increased regulatory costs.

This is partly because regulators generally craft the rules while keeping in mind that small banks have different business models.

Indeed, a report by the Congressional Research Service noted that regulators are careful in not pursing a “one-size-fits-all” approach. The report noted that the regulators carefully consider the effect of rules on small banks during the rulemaking process.

Regulators have exempted about 90 percent of commercial banks with assets of less than $1 billion from higher capital requirements for example, and excluded multifamily housing mortgages, and construction loans from the definition of high volatility loans.

Overall, the report noted that 13 out of the 14 major rules issued pursuant to the Dodd-Frank Act include an exemption for small banks, or are tailored so as to reduce the compliance cost for them.

Measuring the cost of the regulatory burden

The anecdotal evidence about regulatory cost for small banks is unscientific, and quantifying the cost is difficult, primarily because these banks do not normally separate regulatory costs from other costs in their call reports. Various interviews conducted by regulators indicate that small institutions do not track regulatory costs because it is too time-consuming, costly, and too interwoven into their operations.

In the last few years, however, regulators have devised relatively simple models in an attempt to estimate these costs.

Most notably, a study by the Federal Reserve Bank of Minneapolis created a flexible model in which the only inputs were (i) the number of additional staff hired, and (ii) their compensation. As incomplete as this may be –because it fails to capture the additional “hidden” costs such as compliance-related training expenses, the opportunity costs (time allocation for non-revenue generation activities) and additional costs related to potentially more risk-taking behavior by banks, it nonetheless provides a “bottom line” figure.

The study found a direct increase in marginal cost (hence lower profit margins) as the size of the bank gets smaller. For example, banks with assets below $50 million would experience a drop in their return-on-assets of nearly 23 basis points (and 18 percent of them would become unprofitable as a result), as opposed to larger size ones that would have an 11 basis point or less. No surprise there.

Even under an alternative scenario, where larger firms hire a disproportionally higher number of employees than smaller firms, the smallest group still has a significant share of the newly unprofitable firms, according to the study. This shows, again, that the highest regulatory burden is felt by the smallest banks.

While these findings show that the smallest banks are the most affected by increased regulation, they ignore the contribution that the use of third parties brings to the bottom line. Since most small banks use consultants and vendors in handling work related to some of their regulatory compliance, the real cost may indeed be lower because these contractors can spread out their fixed cost using economies of scale, just like the compliance departments of larger banks.

An emerging counter-trend

In the last few years, regulators have been heeding small bankers’ complaints about their increasing regulatory burden, and sought ways to provide some form of regulatory relief.

Burden recognized

Federal Reserve Chair Janet Yellen has acknowledged on many occasions the different nature of small banks by emphasizing their lack of systemic risk from a macro-prudential perspective, and their disproportionate regulatory load. “We recognize how high the burdens are on community banks, and for our own part we are heavily focused on trying to tailor our regulations,” she said at a Joint Economic Committee hearing last year.

Federal Deposit Insurance Corporation (FDIC) Chairman Martin Gruenberg – as head of the primary federal regulator of community banks — has stated that the FDIC does not support a “push down” of practices from larger to smaller institutions. Indeed, the FDIC has, through constant dialogue via its advisory committee of community bankers, clarifications provided by financial institution letters (“FIL”), tailored its supervisory approach and rulemaking process to the size, complexity, and risk profile of each institution.

Relief provided

In line with these concerns, Fed Governor Daniel Tarullo has called for a tiered approach, where the smaller banks would not be bound by same constraints as their larger counterparts.

Most notable of these initiatives of the tiered approach are the following:

  • the revised capital guidelines for community banks raising the small bank holding company asset threshold from $500 million to $1 billion, thus exempting banks under that level from certain capital rules;
  • an examination program linking examination intensity to the individual community bank’s risk profile (rather than the traditional risk-focused approach) adopted in 2014; and
  • an increase in off-site supervisory oversight while leveraging off of community banks’ electronic records to assess loan quality and underwriting practices.

This last initiative, through its use of electronic pre-examination information exchange, and automation on various parts of the community bank examination process is to reduce the regulatory burden, not only for the community banks but also for their supervisors.

FDIC Vice Chairman Thomas Hoenig also proposed similar regulatory relief for banks without a trading book, non-basic derivatives positions, and a ratio higher than 10 percent of equity-to-assets ratio.

The Consumer Financial Protection Bureau (CFPB) has also eased the regulatory burden when it finalized its QM rule last year, in which it modified the critical definitions of “rural area”, and “small creditor.” These changes allowed a significant regulatory relief for banks with less than $2 billion in assets and that make fewer than 2,000 mortgage loans per year.

There is also a lesser known policy initiative called the economic growth and regulatory paperwork reduction act that stipulates a review of regulation and eliminate those that are outdated, or unnecessary. Tarullo encouraged community bankers to provide suggestions on how to tailor specific regulations to fit their regulatory needs better for the review due to be completed by year-end 2016. Separately, there is a recent congressional initiative underway (supported by the ICBA) aiming to reduce the review’s frequency from 10 to 5 years, and include the CFPB’s rules as well.

Regulatory relief may not be up to their expectations, but in an environment where regulatory burden is ever increasing for their larger counterparts, small banks seem set to benefit from the treatment regulators are carefully according them.

(Bora Yagiz, FRM is a New York-based Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence, specializing in risk. He is a certified Financial Risk Manager. Mr. Yagiz has held positions as a bank examiner for the Federal Reserve Bank of New York, as senior consultant with Ernst & Young and vice president at Morgan Stanley. Follow Bora on Twitter@Bora_Yagiz. Email Bora at

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Aug. 30. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters)

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