, Salem, MA

February 18, 2013

Watson: Dodd-Frank bank regulations have varied effects

Brian T. Watson
The Salem News

---- — As a person who believes in capitalism and the market, and all of the better attributes and consequences of their dynamics, I quite naturally share the concomitant belief that government — to the extent possible — should intervene in or regulate the private sector only when necessary.

But at the same time, I also believe that there have been and are many occasions when government regulation is warranted.

The causes of the housing bubble disaster and Wall Street meltdown of 2007 and 2008 were many. From homeowners to banks to regulatory agencies, nobody performed well. But the recklessness and irresponsibility displayed by some banks, mortgage lenders, ratings companies and hedge funds were enormous and destructive, and that behavior has precipitated new federal regulation.

The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law in July 2010, is legislation that was written as a direct response to the bad practices and abuses that contributed to the crisis. Congress examined the banking system, the financial markets, the explosion of complex financial instruments and the risk standards involved, and attempted to create rules that will reduce the chances of the same mistakes and duplicity occurring again.

The Dodd-Frank bill contains two types of prose. It describes in layman’s terms the broad goals and intentions of the act. It also outlines more technical, specific regulations to achieve those goals. Roughly 30 to 40 percent of the actual Dodd-Frank rules have been written — and they take effect on an intermittent, unfolding basis — while the rest will continue to be written and implemented during the next two years.

This long process is not ideal, but the entire business of understanding and regulating the mammoth, American — but globally interconnected — financial system is incredibly difficult.

Paul Volcker, chairman of the Federal Reserve from 1979 to 1987, calls Dodd-Frank “an important step in the needed direction.” It attempts to do many things. In an effort to control excessive risk and conflicts of interest, it puts new limits on proprietary trading by banks, and restrains their use of hedge and equity funds. In an effort to address the “moral hazard” of very large banks taking very large risks — knowing they are too big for the government to allow them to fail — the legislation requires banks to create their own rescue fund, and it hopes to establish orderly rules (living wills) for the liquidation of big banks, or parts of those banks.

New rules will attempt to restrain the mischievous use of many kinds of derivatives, credit default swaps, collateralized debt obligations and other heretofore absolutely opaque constructs. There will be more rules governing loan underwriting standards, the bundling and selling of mortgages, and the capital requirements and risk retention of the mortgage originator.

Dodd-Frank also aims to affect executive compensation, the integrity of the ratings companies, the registration of investment advisers, the soundness of corporate governance and the protection of financial consumers.

Many of the more significant reforms, such as participation in the bank-funded “bailout” fund, are mandated only for banks with assets in excess of $50 billion. This is appropriate. The six largest financial institutions in the U.S. now account for about 55 percent of all banking assets.

But 7,000 of the roughly 7,600 banks in the country each have less than $1 billion in assets; these are “community banks,” and in many cases, their culpability for the Wall Street meltdown was almost zero.

I spoke with Michael Wheeler, president of Beverly Cooperative Bank, to learn how Dodd-Frank is affecting smaller, local banks.

Beverly Cooperative, founded in 1888, has four branches, 72 employees and $300 million in assets. It is growing, and last year gave out 206 loans. During the past 10 years, it has given out about 225 loans per year (125 commercial, 100 residential, on average). What is most impressive is that the bank has had less than 10 loan failures in that 10-year span of 2250 loans.

Although Wheeler acknowledges that new regulations were necessary to respond to a range of problems — from predatory loans to the irresponsible use of derivatives — he points out that, by far, the largest incidence of bad practices came from the few hundred biggest banks and lenders. The top 10 banks today still initiate 70 percent of all lending.

Wheeler believes that Dodd-Frank and the Consumer Protection Financial Bureau are burdening community banks with regulations where there has been little problem. He has a point, and Beverly Cooperative’s track record backs him up. During the housing bubble buildup, the bank’s loan underwriting standards did not deteriorate, nor did the bank take advantage of unqualified or financially illiterate loan applicants.

Yet, in the past year, at an additional cost of between $100,000 and $200,000, the bank has had to increase staff time and outside consulting hours significantly to interpret and implement new regulatory compliance.

There is a very real risk that banks smaller than Beverly Cooperative Bank — say, less than $100 million in assets — will not be able to absorb these costs, and therefore may be closed, or may be purchased by larger banks. Either way, the local community is the loser — either no bank at all, or a larger, less responsive bank.

Will Dodd-Frank be successful? My discussion with Beverly Cooperative executives reinforces something else Volcker said. He said that regulators are often outgunned. If senior executives at the big banks don’t set the tone and discipline and ethics that they require of their institutions, it’s unlikely that any set of regulations will succeed.

During the bubble, Beverly Cooperative executives had the integrity to run a responsible bank, and I suspect that they don’t require additional auditing to continue that practice. The big question is: What will it take to elicit best practices from the larger institutions of the industry?


Brian T. Watson is a regular Salem News columnist. Contact him at