Is it time to rethink some common assumptions about financial regulation?
That the last few decades have seen significant deregulation in the financial sector is a popular narrative advanced by popular commentators and professional economists alike. Even after the significant rise in regulation due to the passage of the Dodd-Frank Act, which massively increased financial regulation, we continue to see commentators express concern over deregulation. But I’m getting ahead of myself.
Rather than rely on narratives about the passage or repeal of specific laws, there are data sources available to us that provide objective measures of the level of financial regulation at the federal level. Economists at The Mercatus Center at George Mason University have used machine learning algorithms to determine the number of regulatory restrictions in the Code of Federal Regulations (e.g. words like “must,” “shall,” “required”) and the probability that a given part of the code applies to a specific industry.
The graph below shows the relative number of regulatory restrictions (2005 = 1) in Title 12 – Banks and Banking of the Code of Federal Regulations on financial intermediaries from 1970 to 2007, with a line of best fit.
Over this time period, there was only one sustained downward trend in financial regulations during the early 1980s. Subsequent increases in regulation during the Savings and Loan crisis more than made up for that decline. Overall, there was a roughly 2% increase in regulation per year.
Extending the timeline forward, we can see that financial regulation has increased dramatically in recent years. Specifically, since the passage of the Dodd-Frank Act in 2010, regulatory restrictions imposed by a slew of executive branch agencies have skyrocketed. In fact, there was roughly as much growth in financial regulation from 1970 to 2009 as there was from 2010 to 2014.
It’s clear that, despite popular narratives, we have seen a consistent, sustained increase in regulation in the financial sector. While it’s certainly possible that many of these regulations have had beneficial effects, they are likely also to cause unintended negative consequences.
One specific manifestation of these unintended consequences is their differential impact on smaller banks. Regulatory compliance costs function as fixed costs, and such costs are more readily absorbed by larger banks than smaller ones. Think of it this way: all the increased communication and paperwork required to comply with the regulations requires additional personnel resources. These additional personnel do not bring in any additional revenue, so the cost of their employment must be spread over existing revenue.
Smaller banks will have to hire more compliance personnel hours per account than larger banks, they will bear relatively higher costs due to the regulations. A survey of small banks bears out this unintended consequence of added regulation.
The decline in the number of small banks in recent years is a likely consequence of the disproportionate impact of regulation.
Given the importance of small banks in the agricultural sector, I have had some interest in measuring the impact of increased bank regulation on small lenders. My colleague Brady Brewer and I are currently working on a paper that examines the effect of banking regulation on the profitability of lenders in the U.S. We use financial data on all banks in the country from 1990 to 2014 and the regulation data cited above to determine whether 1) banks are harmed in terms of profitability by regulation and 2) small banks are disproportionately affected by said regulations.
Our preliminary findings indicate that regulations have economically significant negative effects on bank profitability and that smaller banks are disproportionately affected by such costs.
Some of the provisions of Dodd-Frank certainly could have been necessary to correct problems in financial markets which were not addressed by previously-existing regulations. However, the notion that we have seen large, sustained reductions in regulations over the past several decades is patently false.
Though they might be beneficial in some ways, they impose costs on lenders that likely offset some of the benefits they provide. The regulatory reform efforts of the new administration can be crafted in a way that strikes a better balance between the intended benefits and unintended costs associated with financial regulation.
Levi A. Russell is an Assistant Professor at the University of Georgia.