Rolling Back Dodd-Frank: Investors’ and Banks’ Responses to Financial Market Deregulation

In the wake of the 2007-2008 financial crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Dodd-Frank created a new financial regulatory landscape with intensified federal oversight and an extensive set of regulations on banks, such as stress tests and stricter capital, trading, loan, and mortgage underwriting standards (Acharya and Richardson, 2012; Richardson et al., 2018). These new regulations have triggered a debate over their benefits and the burden they place on banks. Since April 2016, and in May 2018, Congress passed the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCP Act), which makes the largest changes to financial regulatory law since 2010 (Tracy, 2018).

In a recent paper we study the economic consequences of financial market deregulation by answering two questions: (a) Do shareholders believe lower regulatory scrutiny enhances the value of banks, and (b) do the lower compliance costs resulting from deregulation prompt banks to improve their operating performance and expand their lending activities?

We take a broad sample of 25 events between April 2016 and May 2018, including deregulation bills, congressional discussions, hearings and votes, presidential speeches and executive orders, and Treasury press releases. Using event study methods, we find a mean increase of 1.41 percent in banks’ three-day abnormal  stock returns around the announcement of deregulatory events. For an average traditional bank in our sample, this increase translates into a rise in shareholder value of $65.2 million. The positive reaction to regulatory relief indicates that shareholders expect improvements in banks’ operating activities. If banks no longer have to use their resources to conduct stress tests or meet stringent liquidity, trading, or mortgage underwriting requirements, they can likely operate without worrying about restrictions and regulations.

Second, while we find an overall positive stock market reaction, we observe that the shareholders of banks with assets below $10 billion react more favorably to deregulation in general and to the introduction of the EGRRCP Act in particular. One obvious reason is that the EGRRCP Act exempts banks with assets below $10 billion from the stricter mortgage-underwriting standards (Perkins et al., 2019).

The overall positive stock price reactions are in line with the notion that Dodd-Frank imposes steep compliance costs on financial institutions and limitations on their business activities. For example, Hogan and Burns (2019) find a total annual increase in Dodd-Frank related compliance costs of $64.5 billion for banks with more than $10 billion in assets. Bouwman et al. (2018) show that banks slow down their asset growth to stay below the two asset thresholds that determine the extent of regulation ($10 billion and $50 billion), thereby avoiding the unique set of rules that apply to financial institutions above those thresholds.

Examples of the increased regulatory burden for banks with assets above the $10 billion and $50 billion thresholds include the mandatory creation of internal risk committees and the conduct of stress tests. The costs of conducting a stress test and disclosing the results range between $150 million and $250 million (LaCapra, 2014; Sterngold, 2015; Tracy and Turner, 2015).

In another set of tests, we examine changes in banks’ asset level, capital structure, lending activity, and performance after the May 22, 2018, passage of the EGRRCP Act. If banks improve their capital structure and operating activities after May 22, 2018, we can reasonably assume that financial market deregulation increases value for shareholders.

Although the EGRRCP Act decreases the compliance costs of banks with more than $10 billion and  $50 billion in assets by raising the threshold at which they face stricter rules to $250 billion, we do not observe positive firm outcomes for these banks. One possible explanation is that these banks consider their initial investments in their Dodd-Frank compliance systems as sunk costs.

However, our analysis shows that small banks with assets below $10 billion expand their lending activities, experience a positive growth in assets, increase their external financing, buildtheir capital strength, and show better accounting performance. These positive outcomes are consistent with the stronger stock market reaction revealed in our event study and lend credibility to shareholders’ positive assessment of financial market deregulation.

The rollback of stricter mortgage underwriting rules in the EGRRCP Act for small banks has likely spurred more lending and positively affected the success of their lending activities. However, the loosened underwriting rules alone cannot sufficiently explain the positive changes in small banks’ asset level. Instead,  the eased regulations for large banks with assets above $10 billion and $50 billion have likely made small banks more willing to grow again and cross the $10 billion asset threshold.

Viewed collectively, our results show that banks’ shareholders respond favorably to less regulatory oversight. We also find some evidence that banks engage in activities that create real shareholder value. The positive firm outcomes for small banks demonstrate the potential practical relevance of a meaningful reduction in regulatory burden and compliance costs.

REFERENCES

Acharya, V.V., Richardson, M., 2012. Implications of the Dodd-Frank Act. Annual Review of Financial Economics, 1-38

Bouwman, C.H.S., Hu, S.S., Johnson, S.A., 2018. Differential bank behaviors around the Dodd–Frank Act size thresholds. Journal of Financial Intermediation 34, 47-57

Hogan, T.L., Burns, S., 2019. Has Dodd–Frank affected bank expenses? Journal of Regulatory Economics, 214-236

LaCapra, L.T., 2014. Banks are not getting much use out of U.S. stress tests. In: Reuters, June 11, 2014

Perkins, D.W., Getter, D.E., Labonte, M., Shorter, G., Su, E., Weiss, N.E. 2019. Economic growth, regulatory relief, and consumer protection act (P.L. 115-174) and selected policy issues. Congressional Research Service

Sterngold, B.J., 2015. Fed broadens scope of stress tests. In: The Wall Street Journal, March 9, 2015

Tracy, B.R., Turner, M., 2015. Foreign banks brace for Fed stress tests. In: The Wall Street Journal, March 2, 2015

Tracy, R., 2018. The fine print: What’s in the Bank Deregulation Bill. In: The Wall Street Journal May 21, 2018

This post comes to us from professors Michael H.R. Erkens at Erasmus University Rotterdam and Nyenrode Business University and Ying Gan at Erasmus University Rotterdam. It is based on their recent paper, “Rolling Back Dodd-Frank: Investors’ and Banks’ Responses to Financial Market Deregulation,” available here.

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