The Spectacular Too Big Failure of Dodd-Frank

The Spectacular Too Big Failure of Dodd-Frank

  • Quick-to-fix regulation often creates unintended consequences
  • Dodd-Frank ultimately destroyed the community bank
  • Consumers lost choice and completion, although farmers were hurt most
Chip Somodevilla/Getty Images

Not much unites the activist Left and activist Right, and not much ever has. After the near-collapse of the fiscal sector in 2008, though, populist movements on both sides found momentum in opposition to government bailouts of private-sector firms, especially in the financial industry. 

“Too big to fail” became a mantra used to leverage massive taxpayer bailouts of financial institutions. Those bailouts enraged conservatives who believed that government had largely created the “too big to fail” players that needed rescuing from bad government policy. At the same time, progressives angrily denounced the parachutes provided to Wall Street fat cats while ordinary Americans suffered through a period of tight lending and a poor economy -- especially in the labor markets. 

Related: How Wall Street Is Fighting to Rip Off Your Retirement Money​​​​ 

By the time 2010 rolled around, the two sides could agree on one thing: changes were necessary to unwind “too big to fail.” Conservatives wanted to push government out of lending and finance through tax and regulatory reforms that would end rent-seeking behaviors that perpetuated it. Progressives wanted more regulation and government intervention to force the industry to behave better. 

Since Democrats controlled Congress and the White House in the spring and summer of 2010, they chose the progressive policy. Congress passed and President Barack Obama signed the Dodd–Frank Wall Street Reform and Consumer Protection Act in July of that year – not long after passing the progressive Affordable Care Act that created massive government intervention in the health-insurance industry. 

For the past eighteen months, the news media has focused on the failures and incompetence of the Obama administration in the ACA’s rollout and infrastructure. The impact of Dodd-Frank has largely been ignored, until now. According to a new study by the Harvard Kennedy School of Business, the attempt to end Too Big to Fail backfired – in a big way. 

One problem that led to TBTF was industry consolidation, which had been steadily reducing the number of smaller community banks that made lending much more accessible to small business owners, farmers, and middle and working-class families. Over the past twenty years, the share of US lending handled by community banks has fallen by half, from 41 percent to 22 percent, while the share handled by large banks more than doubled from 17 percent to 41 percent.  

Related: In the Obama White House, It’s Deficits as Far as the Eye Can See ​ 

One of the factors driving that consolidation was “economies of scale,” the GAO found in an earlier study. The FDIC noted that was a particularly strong factor for banks that did more than $100 million a year in lending. Dodd-Frank actually made this worse, thanks to the massive amount of new regulation and its attendant compliance costs. 

The impact fell hardest on community banks, which made them less competitive and more likely to be consolidated. “[Larger] banks are better suited to handle heightened regulatory burdens than are smaller banks,” the study notes, “causing the average costs of community banks to be higher.” 

The competitive disadvantage is significant. The study quotes testimony before Congress in 2012 from the chair of the Community Bankers Council of the American Bankers Association, William Grant, who said that the average compliance costs for banks in the post-Dodd-Frank world was 12 percent of operating costs. However, for community banks, “[The] cost of regulatory compliance as a share of operating expenses is two-and-a-half times greater for small banks than for large banks.” 

As a result, it now drives consolidation in the financial industry at a greater rate than before and during the Great Recession. Since passage of Dodd-Frank, the assets of small community banks have dropped 19 percent. That has had an impact on access to loans, especially in agricultural lending needed by local farmers. While demand has increased for such loans, largest bank lending in this area dropped 9.5 percent, leaving local farmers with fewer and fewer options. “Clearly, consolidation of the banking sector is not driving the largest financial institutions to engage in agricultural lending.” 

Related: Is the Unemployment Rate of 5.7 Percent Just a ‘Big Lie’?​ 

It’s not just agricultural lending where the impact of regulatory-driven consolidation can be seen. In commercial and industrial lending, the larger banks have seen a boost in market share (although not the top five largest). Community banks have lost 22.5 percent of their market share in this area, with the smaller community banks dropping over 35 percent. Even in individual lending, where community banks should be able to compete on proximity to the borrowers, the larger banks have increased their market share by 36 percent, while community banks of all kinds have retreated by 8 percent -- and the smaller community banks have lost 18 percent of the business. 

Bloomberg Businessweek noted in 2013 the compliance-cost pressure for consolidation comes not just from the bottom up with Dodd-Frank, but also from the top down. “Crossing the $10 billion threshold subjected the Houston-based bank to a variety of regulatory hurdles under Dodd-Frank,” reported Leslie Picker and Matthew Monks. At the same time, smaller banks feel forced to merge “to swallow the costs of complying with new rules” of Dodd-Frank. 

If the point of Dodd-Frank was to eliminate TBTF, it’s clearly failed. Instead, what it has done is prove the point of conservatives, who have consistently argued that regulatory expansion disproportionately impacts smaller players in any market. Larger players know this and leverage their influence to get legislators to expand regulation in a way that burdens their smaller competition. Eventually, it incentivizes them to either leave the market or get swallowed up by consolidation. 

If the point of Dodd-Frank was to help consumers, that too has been a failure. Consolidation reduces both choice and proximity for most consumers, and the data from Harvard amply demonstrates that in the wake of Dodd-Frank. Rather than provide more competition for service and price, consolidation has left borrowers more and more at the whims of fewer and fewer providers, and agriculture in particular has suffered the most.  About the only success we see from Dodd-Frank is the strengthening of lobbyists on Capitol Hill, particularly from Wall Street. 

This should serve as an object lesson about the nature of progressive reform and its impact on markets and consumers. Massive regulatory interventions rarely provide reform, and as we have seen in Obamacare, often exacerbate the very conditions they are supposed to resolve. Perhaps it’s time to try Option A in both cases. 

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