Safety, but at What Price?

by J. Mark McWatters, Acting Chairman

All human endeavor involves risk. The activities of financial institutions involve risk-taking by their very nature, and no degree of risk management or government regulation can reduce that hazard to zero. The elimination of risk from the operations of depository institutions is neither possible nor desirable.

To be sure, credit unions occupy the lower end of the risk spectrum, as they should. However, the extension of credit to consumers and businesses is inherently risky, and there is often a direct relationship between risk and need.

In an environment of rising regulation, the stability that is gained from new rules comes at the price of the resources diverted to compliance from other productive activities. As rule is piled on top of rule, the law of diminishing marginal returns takes hold and each additional compliance dollar results in a smaller increase in safety.

Taken to extremes, excessive regulation eventually leads to negative returns in stability. This occurs when mounting costs and rising inefficiency are such that regulation itself becomes a threat to institutions.

Which brings me to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

The 2008 financial crisis resulted in a flood of new federal rules that is still cresting. Whether the regulations that have been promulgated target the correct parties and behaviors is a matter of ongoing debate. However, these things we know for certain: the rising regulatory burden is affecting institutions of all sizes and consumers are feeling the effects.

The high implementation costs, prescriptive standards and litigation risks associated with new rules on lending are being priced into loan products. They are also making many lenders less likely to extend credit. Corporations and wealthy individuals have alternative sources of funding. Small businesses and middle class borrowers often do not. When consumer access to credit is made more limited and costly, it is those with imperfect credit and modest incomes who feel it first.

Similarly, the price of regulatory compliance imposes disproportionate demands on the staff and budgets of smaller credit unions lacking in economies of scale. When fixed costs associated with compliance are spread over the smaller asset base at these institutions, they can strain earnings and contribute to consolidation within the industry.

As new rules squeeze the financial sector, consumers are left with fewer options. Today, there are more than 1,500 fewer credit unions and more than 1,400 fewer commercial banks in America than there were six years ago. While difficult to quantify, there is little question that the regulatory drag imposed by Dodd- Frank has contributed to consolidation. And fewer competitors means less competition and reduced choice.

Data quantifying the financial impact of Dodd-Frank on credit unions is limited. However, related studies shed considerable light on the potential cost. In 2014, researchers at the Mercatus Center at George Mason University reported the results of a nationwide survey of 200 small banks. The institutions surveyed were under $10 billion in asset size, with most holding under $1 billion in assets.

Of the banks surveyed, 83 percent indicated that Dodd-Frank compliance had increased their costs by more than 5 percent. The median number of compliance personnel at these institutions increased from one to two, with over a quarter of respondents indicating they anticipated adding additional compliance staff to deal with the rising regulatory burden. To put this into perspective, an unrelated 2013 study from the Federal Reserve Bank of Minneapolis found that adding a single compliance employee would reduce the return on assets at banks with under $50 million in assets by approximately one-third.

That is a significant cost increase. And while banks, no matter how small, are not credit unions, the implications for credit unions and their members are clear. In 2016, the 3,510 credit unions nationally with less than $50 million in assets averaged $35,141 in net income. Yet, they paid an average of $52,165 in salary and benefits per employee. It seems clear that for many small credit unions, having to add a single compliance staffer—on average—could spell the difference between positive net income or a net loss.

In reality, the cost increases associated with government regulation are inevitably passed on to consumers in some form. For context, half of credit unions with under $50 million in assets pay out less than $22,000 per year in interest payments—about $30,000 less than the cost of adding one full-time employee. This helps illustrate the fact that dollars spent on compliance could have gone to higher share rates, lower interest rates on loans and improved member services.

Further quantifying the impact of regulatory costs on customers is a 2014 study of the banking system by the Goldman Sachs Global Markets Institute. Researchers there found that under Dodd-Frank interest rates had risen the most for products with the greatest increase in regulatory scrutiny and that they had risen most sharply for those with less than perfect credit.

Specifically, the study revealed that nonprime residential mortgages and credit cards saw the sharpest rise in rates in the wake of the financial crisis. Researchers estimated that for a household with the U.S. median annual income of $50,000, the estimated increase in mortgage payments and credit card interest came to roughly $200 per year. That is a substantial hit for the American middle class and those who aspire to join it.

No one wants an unregulated financial sector, particularly when the full faith and credit of the United States—and the U.S. taxpayer—is on the line. Credit union members have a right to know that their federally insured savings are secure. If there were any doubt about the need for strong regulators for financial services firms, the 2008 crisis laid the matter to rest.

However, we do well to remember that complying with federal regulations is costly business, and that the cost of compliance adds to the prices paid by consumers and limits their choice and access to credit. NCUA has a critical role to play in ensuring a stable, robust credit union system. However, the system is only as safe and sound as the institutions within it, and the best regulator of prices and products is market competition.