THE COLLAPSE OF BANK ENTRY

SINCE THE DODD-FRANK ACT and Prospects for Recovery

by Dr. Kuan Liu & Dr. Timothy J. Yeager

Before the enactment of the Dodd-Frank Act in 2010, new bank entries averaged about 150 per year. Since then, bank entry has largely collapsed. As shown in Figure 1, bank entries averaged less than seven between 2011 and 2022, though they have increased slightly since 2017. What caused this collapse, and what are the prospects for recovery?

A research study by Dr. Kuan Liu on the impact of the Dodd-Frank Act on community banks finds that additional compliance burdens and higher capital requirements explain about 80% of the collapse of bank entry.1 While both burdens contribute to the decline, they work through distinct economic channels and have different longterm effects. Together, these factors suggest that bank entries will continue to increase slowly over time, but the annual number of entries will remain well below the number in the pre-Dodd-Frank era.

Compliance Costs

To understand entry dynamics in the banking industry, one must focus on community banks because they account for nearly all new entrants. The Dodd-Frank Act imposed additional regulatory burdens on banks through heightened compliance costs. For example, the Consumer Finance Protection Bureau (CFPB) put forth regulations that require banks to conduct ability-to-repay tests before they can originate most residential mortgages. The CFPB also imposed more disclosure requirements on banks to increase transparency to consumers and the public. Large banks can more easily absorb the additional compliance costs because of their large economies of scale. Community banks, on the other hand, have much less capacity to absorb fixed costs so higher compliance costs have a greater adverse effect on profitability. Lower profits, in turn, reduce bank charter values (discounted future profits), which reduces the attractiveness of starting de novo banks.

The adverse impact of higher compliance costs on new bank entry is temporary. Although this result may seem counterintuitive, banking markets adjust over time to recover the charter value decline. Reduced profitability drives weak banks to exit the industry while healthier banks reduce average costs by increasing their scale via organic expansion or acquisitions. A consequence of this growth and consolidation is that loan supply decreases with the number of banks, which puts upward pressure on loan rates and enhances the profitability of surviving banks. Consequently, higher compliance costs depress profitability only until these market adjustments are completed. If higher compliance costs were the only regulatory burden imposed, charter values of surviving banks would fully recover, which would also lead to a full recovery of bank entry in the medium-to-long run.

1. Dr. Liu’s research paper is titled “The Impact of the Dodd-Frank Act on Small U.S. Banks” and is available at https://ssrn.com/abstract=4653325.

Tighter Capital Requirements

The Dodd-Frank Act also laid the foundation for higher capital requirements. In 2013, federal bank regulators issued rules to align with the Basel III capital standards, and community bank implementation began in 2015. Among other things, Basel III stresses the importance of common equity, strengthens minimum capital ratios, and establishes a conservation buffer of 2.5%. Relative to Basel I, the minimum Tier 1 risk-based capital ratio (plus the conservation buffer) for an adequately capitalized bank rose from 4% to 8.5%.

Community banks hold large capital spreads above regulatory thresholds, in part to ensure survival. Although most community banks could have met the higher Basel III requirements by reducing their spread and leaving capital unchanged, they chose to boost their capital ratios anyway. Figure 2 shows that the average bank with assets between $100 million and $1 billion increased its average Tier 1 risk-based ratio from 13.7% in the years 2000-2006 to 15.7% in the years 2013-2019. In other words, in response to the 4.5 percentage point effective increase in the minimum Tier 1 risk-based capital ratio, the average community bank in 2019 increased its ratio by 2.0 percentage points and decreased its spread by 2.5 percentage points.

Higher capital requirements, therefore, have increased an important component of entry costs. Consistent with this observation, Dr. Liu’s research findings show that the increase in capital requirements postDodd-Frank is the primary contributor to the persistent lack of bank entry.

Prospects For The Future

Notes: The solid black lines represent the mean Tier 1 risk-based capital ratio from 2000-2006 and from 2013-2019.

Source: FDIC call reports and authors’ calculations.

Unlike higher compliance costs, the adverse impact of higher capital requirements from Basel III on new entry is permanent because a bank start-up must raise more seed capital than it raised under Basel I. De novo banks in the post-Dodd-Frank era recognize that if they begin with relatively small amounts of capital, they are less likely to survive, just as established banks raised capital with the implementation of Basel III. Indeed, as shown in Table 1, the average (inflation-adjusted) initial capital injection of the 954 de novo banks between 2000 and 2006 was $14.7 million, but the capital injection of the 63 de novo banks between 2011 and the first half of 2023 was $38.1 million. (The median capital injection rose from $11.4 million to $23.6 million.) Raising equity in the financial market is a costly process.

Dr. Liu’s research of the effects from increases in compliance costs and capital requirements on bank entry estimates that these factors jointly account for about 80% of the decline in de novo banks since 2010. The compliance burden, however, dissipates over time while the burden from higher capital requirements is persistent. The combination of these factors predicts that new bank entries will gradually rise as banks grow and adjust to the compliance burdens. The annual number of new entries, however, will remain much lower than entries in the pre-Dodd-Frank era due to the higher capital required to start a bank. Indeed, this is the pattern observed thus far in the postDodd-Frank decade. The research model estimates that there will be an average of about 30 new bank entries per year once the banking industry fully incorporates the effects from higher compliance costs and capital requirements.

About The Authors

Dr. Kuan Liu is an Assistant Professor of Finance at the University of Arkansas. Dr. Timothy J. Yeager is a Professor of Finance at the University of Arkansas and holds the Arkansas Bankers Association Chair in Banking.

Notes: Capital amounts are inflation-adjusted. Data include only the 1st half of 2023.

Source: FDIC BankFind Suite: Find Events & Changes