Dodd-Frank Done: There Go The Smaller Banks

by: John M. Mason


President Trump moved on Friday to remove or reduce the regulation of commercial banks created by the Dodd-Frank reform act.

The creation of this Act resulted in many "smaller" banks leaving the banking industry and the removal of the Act will produce a situation in which many more will leave.

There are plenty of other things going on in the world that are working against the existence of "smaller" banks, and this action will just make it that much harder.

The Dodd-Frank Wall Street Reform and Consumer Protection Act has done more to get rid of smaller banks in the United States than any other event other than the Great Depression.

The removal of the Dodd-Frank Act…or, at least the removal of much of the Act…will further accelerate the decline in the number of smaller banks in the United States.

Last Friday, President Trump started the movement to reduce the impact of the Dodd-Frank Act and the stock market took off, especially bank stocks. The NASDAQ index hit another record high and the Dow-Jones and Standard & Poor's 500 closed near their historic highs.

Good news for the banks…especially the larger banks.

The Dodd-Frank Act was signed into law in July 2010. By the time the bill went into effect, the larger banks in the country had already adjusted to the changes that were being made and were ready for the "new" era of banking regulation.

The smaller institutions did not have the financial resources or the administrative ability to make changes that quickly and so had to adjust over time…or, leave the industry altogether.

According to FDIC statistics, there were 7,279 commercial banks in existence at the end of 2007, just when the Great Recession was beginning.

At the end of 2016, there were only 5,170 commercial banks in existence. And, the greatest decline in banks was the institutions with less than $100 million in asset size.

Also since December 2007, the largest 25 domestically chartered banks in the United States controlled 56 percent of the assets in the country. This share rose to 58 percent at the end of 2016.

Also to be noted that foreign-related institutions increased their share of the assets from 12 percent to 13 percent during this time period.

Thus, the largest 25 banks in the country plus foreign-related institutions control 71 percent of the assets or almost three-quarters of the banking assets in the United States.

These shifts were exacerbated by the costs to the "smaller" banks of the Dodd-Frank Act.

But, the trend was in this direction anyway, the Act just accelerated the decline.

And, it is my belief that this decline will continue over the next 5 to 8 years, with the decline accelerating again due to the removal of the Dodd-Frank Act.

I see no reason for having more than 1,000 commercial banks in the US banking system, and the number should probably be even less than this.

There are three reasons why this decline in bank numbers will continue…even speed up.

First, there is the economy. The slow economic growth during the current recovery with the absence of much business investment has cut down substantially on commercial and industrial loans at commercial banks. Real estate loans, especially commercial real estate loans, have become the major component of bank balance sheets, and this along with financial dealing have come to dominate because there has been little economic expansion.

Even with an additional spending and tax relief coming from the Trump administration, economic growth will remain modest over this next 5- to 8-year period.

Second, the Federal Reserve will be raising interest rates during this period of time and although this will supposedly help improve bank net interest margins, I believe that the competition coming from other financial sources will tend to keep net interest margins contracted. Financial intermediation in this "new" technological era will just not allow things to go back to where they were.

Third, there is the technological innovation that will take place over the next five years or so. Everyone started to talk about how money was going to "go away" and bank branches were legacy in the late 1960s at the Automatic Teller Machines were put into place…but this did not happen.

Now, the banking industry is really starting to "catch up" with the rest of the world in terms of information technology and I believe that the FinTech revolution will just take over and really revolutionize finance. The "smaller" banks will just not have the financial resources or the human capital to compete in this new environment.

Which gets me back to the issue of deregulation. The deregulation that Mr. Trump's actions may open up will only be caught up in the FinTech revolution and make it even more difficult for the "smaller" commercial banking institutions to stay competitive. Again, this just provides added pressure on the "smaller" banks to exit and not have to deal with all the complexities and costs of adjusting to the "new" environment.

Finally, there is the overall question about the viability of having a large number of banks around. One of the historic reasons for having regulation was to limit banking markets so that financial institutions could have local or regional monopolies or oligopolies which would allow for them to create sustainable competitive advantages.

The evidence of sustainable competitive advantages is that the banks would be able to earn a return on shareholder's equity that significantly exceeded their cost of capital.

In today's environment, local and regional barriers to competition have gone away and competition has become from many other sources than just banks. As a consequence, fewer and fewer commercial banks are covering their cost of capital, roughly estimated to be around 10 percent in the United States.

Only one of the top six largest banks has been modestly above a 10 percent return on shareholder's equity during the recovery from the Great Recession and that has been Wells Fargo…whose ROE has been dropping toward 10 percent since the recent "scandals."

Note that this is not a problem just in the United States. A report, just recently released by the Bundesbank, states that "only one in five German banks will earn their cost of capital by the end of the decade if interest rates stay where they are." And, the German banks in the European Union are not the only banks facing this problem.

Bottom line: there are strong forces in place causing the number of commercial banks in the banking system to decline, but the deregulation created by the removal or reduction or rules in the Dodd-Frank Act will only increase the number of bank mergers taking place in the near future and get us to a substantially lower number of banks in the system sooner than it would have happened otherwise.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.