The cost of regulation

The cost of regulation

People always expected large banks to complain when new regulations hit the wires because they had been at the centre of the "too big to fail" debate and the primary target for the regulator. Surprisingly though, it is the small banks that are in the news now. The Wall Street Journal reported that these same small banks that did so well during the crisis are having serious profitability issues now, calling this effect "too small to succeed."

Tough Times for Tiny Banks. Source: The Wall Street Journal.

Funnily enough, they pointed to the new regulations designed to make banks smaller. They said that the cost of regulatory compliance was way out of their budget. Some said well how much do small banks matter, who really needs them? Well it turns out there are over 5,400 "small" banks in the US with assets under $1bn. That's 5 trillion dollars! So the Federal Reserve Bank of Minneapolis, one of the 12 branches of the US Central Bank, conducted a study in 2013 to delve into this issue and puts some numbers to all the talk.

The conclusion is decisive: there is no cost-effective way for small banks to adopt new regulations. Whether hiring staff, re-focusing existing staff, external consultants, building or buying new IT systems for a "non-revenue" function weighs heavily on the profitability of banks at the smaller end of the spectrum (Assets<$50mn), with a single new hire decreasing the overall Return on Assets by up to 0.23%.

This may not sound like a lot, but 0.23% is HUGE, when you consider that the Fed Funds Rate is 0.09%. To make matters worse, the Fed supposed that firms at the larger end of the spectrum (Assets close to $1bn) will have higher costs and hire more staff resulting in even greater impact on profitability. Looking at the Minneapolis Fed's findings below, we see that this puts 374 banks below the minimum profitability threshold of 0.4%!

This has astounding implications because it demonstrates that banks throughout the spectrum are feeling the pain of new regulations on their profitability. If we extrapolate the costs incurred to larger banks we seem some interesting results:

Large banks like JP Morgan ($2,500bn of Assets) will need hundreds of new employees (or IT expenses) to deal with new regulations. A recent Bloomberg article highlights Deutsche Bank's EUR 1bn effort for regulatory concerns with over 1,300 dedicated staff. 1,300 employees that do nothing for the banks profitability! In the Fed's study, a new regulatory expert would command a salary of $70k in rural areas and $90k in urban. At a large, systemically important bank, a regulatory expert might make $100-250k depending on bank size. This means a bank with $500bn in assets (ex. Danske Bank/Bank of Nova Scotia) will be spending a minimum of $50mn to implement new regulations. Sure, it is only 0.01% of total assets. But if we consider the $223tr of worldwide assets, then that is a minimum of $22.3bn in additional annual operational costs globally that should be avoidable. We are looking forward to this challenge.

- Suade Labs (September 2014)

Update! A friend showed me this OECD Working Paper that put the total cost at 5-15bps (which is roughly $100bn globally). So basically, it's kind of a big deal.

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