Too Small to Survive? Possible consequences of Dodd-Frank Act

Darius Palia, a finance professor at Rutgers Business School, believes the sweeping reforms contained within the Dodd-Frank Act are proving to have a steep, unexpected price tag.

The two-year-old federal law, inspired by the collapse of the financial industry and the ensuing “Great Recession,” was intended to prevent another financial crisis by imposing new requirements for transparency, accountability and consumer protections.

But recently, some unintended consequences of the law, namely the crushing burden on banks to meet these regulations, are starting to be raised by industry observers.

Palia raises the question on how the mounting costs of complying with the Dodd-Frank requirements are coming under increasing scrutiny and need some justification. The implications of Dodd-Frank rule-making and implementation and the insights gained from the financial crisis of 2008 will be discussed during a conference hosted by the Financial Institutions Center at Rutgers Business School on November 9. Palia is the founding director of the Financial Institutions Center. Please register to attend (seating is limited) if you are interested in shaping the post-election debate on financial regulation. [See agenda]

Palia on the unexpected consequences of Dodd-Frank:

Compliance is increasing costs on all banking institutions. The question comes down to, do regulators know the costs. I don’t think the banking industry knows the cost. Each bank knows its own costs. We’re starting to look at some of the direct costs of the regulations. If banks have to add software, hardware or more people for these new requirements under Dodd Frank, what are they costing? If we can aggregate these costs, we can say to the regulators, this is the cost, now tell us what is the benefit?

I’m not saying that there aren’t benefits, but at least there would be some quantitative way of assessing. Then people could ask if you’re a $100 million bank, can you afford to be in business with these bare minimum rules?

One of the bankers who will participate in an upcoming panel discussion (“Risk Management at Medium and Small Banks”) during the FIC conference is the CEO of a small bank. They had nothing to do with the crisis, but they’re paying the price. He’s going to talk about whether there is, inadvertently, now a minimum size for a bank to exist as a result of these laws. (The FIC conference will be hosted by Rutgers Business School on Nov. 9.)

Clearly, everyone has the same objective, regulators and the good bankers who want to curb excessive risk-taking. That’s the objective and that’s important, but are they doing that or are they mostly just creating compliance costs with regulations that won’t ever catch any excessive risk-taking.

Now, if banks want to introduce some products, they have to go through a lot more hoops. That’s fine if the requirements are optimal. At least we need to start assessing the costs of regulation to help see if it is justified.

We now clearly understand how the financial crisis happened with a lot of people at fault. Regulators didn’t catch this, bankers misbehaved, home borrowers overleveraged.  Everybody had a hand in this. No one wants this to happen again, but there has to be some sort of cost-benefits analysis going on. We’re just starting to ask about this. Supposing people said look, the cost is $500 million dollars nationally (I’m just making up a number). Then they’ve got to say half a billion dollars a year is being spent on compliance costs. So show us which areas you caught someone doing excessive risk-taking. Suppose they can’t do that? Then where is the justification? We’re just starting to ask this question. Are we feeling better because of these compliance issues or are they really having some benefit. If they say someone made a $30 million bet and they’re spending $500 million a year to catch them, then we have to ask, is there a better way to do this?