In this brave new world of ever-expanding compliance requirements (from Sarbox and the Patriot Act, to Dodd-Frank and Basel III), do not let Wall Street's crying and complaining fool you. In secret, big banks love government regulation.
Without question, these new compliance requirements will hurt the bottom line of every financial institution – large or small – and, in countless cases, deservedly so. After all, many of these industry veterans orchestrated one of the greatest schemes of all time, where profits were captured internally by an elite few and losses externalized on the taxpaying public. Bureaucrats, in response, attempted to bolster the financial system by introducing a number of new laws and regulations. Today, in order to comply with increasing regulatory standards, all banks, large and small, are watching profits slip and share prices wilt.
However, at this point, the similarities between big and small banks come to an end.
While it might seem counterintuitive, big banks tend to favor increased regulatory burdens because they are better positioned to defend against aggressive new legislation. However, smaller financial institutions, like most community banks, credit unions and mortgage lenders, are at an economic disadvantage and may face financial ruin.
Economics, in simple terms, is the study of actions given scarce resources. Within this framework of scarcity, large banks control vast amounts of financial and political influence. Smaller financial institutions rarely enjoy these luxuries. For example, if ABC National Bank has 5,000 branches nationwide and everyday each branch opens one new checking account with an initial deposit of just $100, then $500,000 in new deposits are created daily. A community bank with a dozen branches cannot compete with that level of productivity.
For big banks with high-volume services such as credit cards, loan origination and insurance boosting revenues, hiring an army of industry-specific professionals – like attorneys, compliance specialists and auditors – is advantageous because operating expenses can be evenly distributed. Similarly, economies of scale give big banks opportunities to contract with political consultants to promote and protect their interests in Washington. As a result, big banks enjoy a level of security and stability not equally shared in the banking sector.
Unsurprisingly, large financial institutions have the flashiest marketing campaigns, most innovative websites and provide consumers with the latest technology. While fancy commercials and cutting-edge equipment does come at a cost, influencing consumers gets a lot easier when technology expenses can be spread across multiple revenue streams.
In contrast, small financial institutions, working with lower volumes and razor-thin margins, routinely fall victim to the "jack-of-all-trades, master of none" business model. While big banks utilize specialists and advanced technology, many small banks have one employee acting as the compliance officer, director of audit and fair lending manager all rolled into one. Further, their technology can be light years behind.
To be fair, many of the opportunities shared by large financial institutions are basic fundamentals of economics that should go unpunished. Concepts like the division of labor, specialization, mass production and economies of scale generally favor large entities that can spread expenses – like compliance costs – across multiple revenue streams. In this case, Bank of America or Wells Fargo is no different than Ikea, Wal-Mart or Apple. As resources are allocated efficiently, these economic concepts are merely the benefits of having a large financial network and rarely imply deception or market manipulation.
However, today, to protect their interests, big banks routinely favor political opportunities instead of market-based ones. This is usually accomplished by supporting barriers to entry, market capture and entrenchment. For example, if the implementation of processes and procedures necessary to comply with new federal compliance requirements is estimated to cost every financial institution $150,000 annually, than larger firms might have an incentive to support the proposed law because it may force out smaller competitors. Using the previous deposit example, even after subtracting $150,000 in added compliance costs, ABC National Bank will still realize $350,000 in wealth creation. Conversely, $150,000 might be a year's worth of profits for a small community bank.
If this example sounds far-fetched, consider that to comply with these hypothetical requirements, federal regulators might recommend that each financial institution implement a new compliance program and hire experienced professionals. In response, all banks, on average, may plan to allocate $80,000 to $120,000 in expenses to hire additional associates and $20,000 to $40,000 to hire a consultant to assist with implementing the new compliance controls. Just like that, the budget allotment is used up. While regulators may take it easy on smaller financial institutions, these burdens are adding up and will eventually become the straw that breaks the camel's back.
While these ever-growing regulatory burdens might sting a bit financially, it is but a small price to pay for big banks. As a result of political opportunities to increase compliance costs, industry leaders will likely relish in the occasion to watch many smaller competitors go out of business while simultaneously gaining their customers. Moreover, future entrepreneurs will think twice before entering the banking sector because of the burdensome regulations, creating a chilling effect that entrenches the big banks and insulates them from further competition.
To make matters worse, large financial institutions routinely issue diplomatic statements such as, "While we do not agree with the broad scope of the proposed regulations, we recognize the importance of consumer protection and will work closely with federal regulators to develop safer bank policies." Publicly, such doublespeak simultaneously portrays big banks as both champions of the free market system and supporters of state intervention, which wins votes on both sides of the political aisle. Privately, however, their only concern is that the regulatory burdens remain high enough to prohibit competition, but low enough to protect revenues and profits.
Ironically, it is government's own good intentions that protect the largest financial institutions, insulating them from competitive pressure. Routinely, big banks and politicians – echoing the "Baptists and Bootleggers" hypothesis – get far too cozy. Instead of nimble banks competing aggressively, more and more are rising into the echelon of "too big to fail."
While size is not necessarily a bad thing, financial institutions that manipulate political and regulatory action in lieu of consumer satisfaction are incentives perversed. So, the next time a Wall Street banker whines about interchange fees or risk-retention requirements, remember he is whining all the way to the bank.
Devin Leary-Hanebrink is a regulatory compliance and risk management professional in Washington, D.C. The views expressed are his own.