Reserve, Tax Inequities Punish Big Banks

Why aren't big banks as profitable as small banks? James E. Watt laid the facts out in his Comment of July 8. He put it in a nutshell when he wrote, "Somewhere above the $1 billion level, banking starts to be less profitable."

But why is that so?

An important part of the reason is not that it is difficult to achieve economies of scale in banking, but rather that large banks bear significant regulatory, tax, and paperwork costs that small banks do not incur.

In fact, recent history provides several good examples of economies of scale achieved by increasing the size of banking units. Many smaller banks have sold their credit card portfolios in the last few years to larger institutions, saying they were forced to sell because they could not achieve "economies of scale." A similar trend toward consolidation can be seen in mortgage servicing.

The economies of consolidation have been recognized by the banking regulators, who have favored intramarket, rather than intermarket, mergers and acquisitions because of the opportunities the intramarket takeovers present to close redundant branches and other facilities.

But bigness has a downside in the form of unavoidable higher costs imposed by statute or regulation. Reserve requirements are a prime example. All banks must hold reserves on demand deposits and nonpersonal time deposits, but as a practical matter reserves are only a burden for larger banks.

Banks must hold a 3% reserve requirement on about the first $40 million of checking accounts, an amount that is not onerous because it is held as vault cash and used in day-to-day business. Above $40 million, the reserve requirement quadruples to 12%, and reserves that exceed permissible vault cash requirements must be held in noninterest-bearing accounts with the local federal reserve bank (or passed to the Fed through a correspondent.)

There is also a 3% reserve requirement on nonpersonal time deposits, which are usually not a very significant portion of a small bank's deposit base. This is primarily a large bank cost.

Idle Money

Large banks hold about $25 billion at the Fed in noninterest-bearing reserve accounts, representing foregone income of more than $2 billion. Naturally, banks try to pass these costs through to depositors and borrowers. But the extra cost makes bank loans less attractive than alternatives such as commercial paper, driving away the best customers, and higher loan rates make repayment more difficult, increasing the risk.

The Federal Reserve recognizes that reserves impose a burden on large banks, and has had a policy position since 1983 in favor of paying interest on reserves. These reserves are held solely for domestic monetary policy purposes, and have nothing to do with safety and soundness.

In another example, state-chartered nonmember banks do not pay the Federal Deposit Insurance Corporation for their examinations. The exams are provided free. State member banks and national banks therefore subsidize their little brethren to the tune of several hundred million dollars, since the cost of those examinations is paid from deposit insurance premiums.

Constant Examination

The largest banks not only pay for their own examinations, but are examined virtually continously, rather than periodically, by permanent resident examination teams, and must provide office space and staff support for the examiners.

Small banks enjoy preferential tax treatment vis-a-vis large banks, notably in the tax treatment of bad-debt reserves. Large banks must fund bad-debt reserves with after-tax income, and can only take a tax loss when the actual loss is recognized.

Banks that are under $500 million in assets have the option to take the tax loss at the time they fund the bad debt reserve. Obviously, troubled loans can require loan loss reserves long before the loan finally goes completely sour, and this law requires large banks to tie up significant amounts of money in premature tax payments.

Some Breaks for Small Banks

While paperwork burdens imposed by regulation are costly for all banks, small banks are exempt from many government reporting and information requirements that large banks must meet. In addition, the costs of certain regulatory requirements, such as currency transaction reports, fall more heavily on large banks because they are normally located in urban areas. Many of these paperwork requirements have no business purpose and are strictly for the convenience or use of the government.

The few examples illustrate the point that small banks enjoy substantial cost advantages over large banks because of favorable government policies. Banking is a low margin business, and most bankers would be delighted with a 1% return on assets. With margins so narrow, extra costs have a brutal effect on profits.

Why government imposes these largely unnecessary higher costs on large banks, which provide services to 80% of the population, is a mystery. The costs simply make the system less efficient, more expensive, less competitive, and weaker, to the detriment of the entire economy.

The fact is that economies of scale are not absent from banking, they are simply overwhelmed. This should be viewed as a signal that the system is ailing and needs to be restored to health.

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