Systemic Rules Magnify Regional Banks' Risk

Large regional banks' solid second-quarter earnings suggested to some that this critical sector is set for smooth sailing. But systemic rules are complicating the outlook for regional banks by making them harder to resolve and less able to lend.

Some regional banks are throwing off operational weight to increase their profitability, but by now the excess cargo is pretty much gone. Any more cost-cutting and banks' competitiveness could suffer. Good seamanship now means charting a course through regulatory obstacles that not only threaten regional banks but also enable many of their most assertive, aggressive competitors.

In a recent paper, we quantified the skinny leeway that regional banks have above many new requirements, most importantly the systemic rules stipulated for them under the Dodd-Frank Act. Some regulatory costs cannot be reliably calculated with public data. But those we could estimate collectively cost the 20 banks in our sample at least $2 billion a year.

These expenses might be worthwhile if they offset real risk. There is no cost too large if it deters another financial crisis. But our study suggests that systemic rules make regional banks riskier rather than safer. And what do these rules do to regional banks' capacity to serve their credit markets? Nothing good.

Our study found that regional banks' minimum of $2 billion in regulatory costs are making them less resilient. Since a series of reforms in 1989 and 1991, very few regional banks have been shut down by the Federal Deposit Insurance Corp. Historically, a faltering regional snapped up by another bank. In extreme circumstances, the FDIC arranges purchase-and-assumption transactions in which another institution takes over at little to no cost to the government.

However, now regional bank holding companies are being forced to meet systemic capital requirements based on risks that they do not pose. To sustain the well-capitalized ratios critical to shareholder return under the new stress tests, these banks will safeguard their own capital and avoid stepping in to acquire a higher-risk bank. Indeed, provisions in Dodd-Frank that limit acquisition to well-capitalized banks essentially prohibit companies from falling below the most stringent capital ratio to handle failing banks. The FDIC thus would do fewer P&As and far more receiverships at considerably greater cost. Even more worrisome is that solvency problems in one region could quickly become a national issue, since large regional banks might fail that otherwise could have been acquired without FDIC assistance.

Systemic regulation also poses a threat to regional banks' lending capabilities. Using well-established methods for calculating the credit impact of additional capital, our study found that the $2 billion in higher capital costs for regional banks would reduce their annual ability to lend by 5.7% to 8%. That might not seem like a big difference. Community banks or big banks could arguably step in to fill the gap. But could they do so in reality?

The very largest banks are, of course, under capital and prudential rules equal to if not more punitive than those governing regional banks under the Dodd-Frank Act. As a result, their credit capacity is at best no greater than that of regional banks. In all likelihood large banks will have difficulty meeting regional credit demand, taking into account the fact that regional loans are usually for smaller amounts. Meanwhile, community banks are too small to pick up much slack outside their hometowns or in large enough volumes to fill in the gap.

This is where nonbank lenders come in. Online marketplace lenders are already showing formidable firepower in small-business lending and related areas. The U.S. Treasury found that these lenders in accounted for $12 billion of business credit in 2014 — a small but not trivial amount. And that's before the full force of all the systemic rules for regional banks kick in. The Treasury's review of online marketplace lending raises concerns about systemic safety, soundness and liquidity as well as consumer protections as banks are squeezed out. Our study shares those concerns.

In short, systemic rules for regional banks do little to make them safer and a good deal more to make them harder to resolve and less able to lend. Cost-cutting could theoretically preserve regional banks' credit capacity, but this would in turn make them less safe. The closer to the bone they cut, the less resilient they will be under stress and the more ill-equipped they will be to repel cyberattacks and innovate to meet changing market needs.

Karen Shaw Petrou is managing partner at Federal Financial Analytics.