The Impact of the Dodd-Frank Act on the Performance of US-Listed Commercial and Savings Banks

Table of Contents

1. Introduction

2. Background and Motivation
2.1 Dodd-Frank: Brief Overview
2.2 Dodd-Frank: Recent Update

3. Literature Review
3.1 Financial Regulation and Firm Performance
3.2 Bank Concentration, Capitalization, and Profitability
3.3 Financial Leverage, Capital Ratio, and Risk

4. Hypothesis Development

5. Data and Methodology
5.1 Data Collection
5.2 Variables Specification
5.3 Regression Model
5.4 Sample Statistics

6. Empirical Findings

7. Robustness Test
7.1 Propensity Score Matching
7.2 Instrumental-Variables Regression

8. Conclusion

References

List of Figures

Figure 1:Small Bank Changes Since Passage of Dodd-Frank (2010 Q2-2013 Q3)

Figure 2: Share of Total US Banking Assets Held By Five Largest Banks vs. Small Banks, 2000-2013

List of Tables

Table 1: Variable Definitions

Table 2: Sample Statistics

Table 3: Pearson Correlation Matrix

Table 4:Multicollinearity Test

Table 5: ‘Diff-in-Diffs’ Estimation Using Linear Regression (Regression Results)

Table 6: Propensity Score Matching Results

Table 7: Endogeneity Test (Instrumental-Variables Panel Data Regression)

Abstract

The impact of financial regulation has critical importance on firm performance and profitability. The aftermath of the Financial Crisis of 2008, which left millions of Americans unemployed, saw the biggest regulatory reform in the U.S. financial system since the Great Depression. One of the main causes of the crisis was the excessive risk-taking by large firms because prior financial regulations had loopholes that firms could take advantage of. Thus, this reform’s intended purpose is to address and fix those failures in past regulatory oversight. With 398 proposed rules and more than 2,000 pages, the Dodd-Frank Wall Street Financial Reform and Consumer Protection Act, more generally known as the ‘Dodd-Frank Act’ and signed into law in 2010, tackles many issues and implements many changes to the financial system. For one, it established new government oversight agencies, such as the Consumer Financial Protection Bureau (CFPB) and the Financial Stability Oversight Council (FSOC);it also outlined new capital requirement standards for banks, aimed to strengthen investor protection, increase the transparency of OTC derivatives, and improve the regulation of credit rating agencies.

Our paper provides empirical evidence on whether theDodd-Frank Acthas any significant impact on the performance of U.S. listed commercial and savings institutions while controlling for bank size. With a sample size of 640 publicly listed commercial and savings banksin the U.S. over each quarter between 2005-2014, we investigate the impact of the Dodd-Frank Act, bank-specific characteristics, and macroeconomic indicatorson banks’ net interest margin, return on assets, and return on equity using a ‘difference-in-differences’ approach.The ‘difference-in-differences’ method is often used in research to examine policy effects.

Our results indicate that the Dodd-Frank Act has a significant negative impact on bank performance, indicated by the net interest margin. Return on assets and return on equity show no significant difference between small banks and big banks. More importantly the interaction term, between the Big Bank dummy and the Dodd-Frank dummy, negatively correlates with bank performance for net interest margin, return on assets, and return on equity.Furthermore, we find that bank-specific characteristics explain a substantial portion of bank performance. Lastly, we conducta robustness test for our results.

In terms of hypotheses testing, on the one hand, we find that the Dodd-Frank Act does impact bank performance, and the robustness test confirms this result. Thus our first hypothesis cannot be rejected; on the other hand, we do not find evidence to support our second hypothesis that the Dodd-Frank Act negatively impacts the performance of small banks more than that of big banks. On the contrary, small banks performed better in the post-Dodd Frank period compared with big banks. The robustness test confirms this conclusion. Thus, we are not able to accept our second hypothesis. Meanwhile, we dig further and provide a few reasons why the performance of small banks is better than that of big banks.

The contribution of our work is that, to the best of our knowledge, our paper is the first to provide empirical evidence on the impact of the Dodd-Frank Act on US-listed commercial and savings banks performance using the most recent data for our analysis. We believe our paper can serve as a good pivot for future research.

Keywords: Dodd-Frank, Financial Regulation, Bank Performance

1. Introduction

The Financial Crisis of 2008 was a defining event that impacted many individuals worldwide.The combination of extreme negative sentiments and the constant media reports at that time had the atmosphere of a modern day 1929 stock market crash. After the panic and confusion had subsided, it was time for the American public to put the blame on someone. After all, millions of Americans were unemployed and trillions of dollars of wealth were lost in the stock market. It was a tumultuous time with the U.S. Federal Reserve beginning their Quantitative Easing (“QE”) operation by purchasing mortgage-backed securities, the U.S. government nationalizing Fannie Mae and Freddie Mac (two large government-sponsored enterprises), and many insolvent banks applying for public bailout money through the Troubled Asset Relief Program (“TARP”).In 2009, financial experts and public officials debated about the root causes of the subprime mortgage crisis and credit crunch that defined the Financial Crisis. The problem of deregulation of the banking industry was raised as a possible determinant and the regulators were questioned regarding the loopholes that surrounded past legislations. By this time, many corporations in the financial industry had come to terms that there would be a change in the regulatory environment. During late 2009, there were already early proposaltalks among the U.S. Senate and House representatives to drafta bill that encompasses all the concerns and problems that regulators had to improve on. Finally in the summer of 2010, the Dodd-Frank Act officially became law.Ever since, there has been an increase in the number of academic research that focuses on the regulatory effectiveness of the Act.

The earliest paper that studied the Dodd-Frank Act was written in 2011. Though brief in length due to the lack of complete details from the Act at that time, the author studieswhether the existing regulatory framework can effectively address the challenges faced by the complexity of modern finance. In other words, Omarova (2011) argues that the approach that regulators took to address the issues surrounding the Financial Crisis is outdated. It does not have the capacity or ability to take into account, for example, complex derivative products stemming from globalized finance and the advancement of financial engineering. The paper concludes that the Dodd-Frank Act cannot deliver the adequate solutions necessary to resolve the problems that caused the Financial Crisis.

The most recent paper regarding the Dodd-Frank Act was published this year. It studies the impact that the Dodd-Frank Act had on small banks by surveying approximately 200 banks across 41 states that met the criteria of having less than $10 billion in assets. From their survey, Pierce, Robinson, and Stratmann (2014) find that small banks are spending more on compliance, with greater than 80% of respondents claiming that their compliance costs has risen by more than 5% since 2010. Additionally, almost 25% of the total banks surveyed are contemplating mergers with other banks as well as reducing their product and service offerings (e.g. residential mortgages) citing increased regulatory burden.Evidence such as this suggests that the environment for small banks has gotten tougher.

Our paper contributes to the banking regulation literature in several ways. Firstly, although there have been academic papers written on the subject of the Dodd-Frank Act, none have yet evaluated the impact of the regulation using empirical evidence to the best of our knowledge. Secondly, our study incorporates the most updated data about the progress of the Dodd-Frank Act. Our paper intends to provide empirical evidence on whether the passage of the Dodd-Frank Act impacts the performance of U.S. listed commercial and savings banks, controlling for different bank size. We chose commercial and savings banks as the target of our study becausethat industry in the U.S. financial sectorcomprises the most number of banks. With the potentially large sample of banks, we can gather a more comprehensiveassessment of the Dodd-Frank Act’simpact. After examining the Dodd-Frank Act, we believe that different bank sizes will be impacted differently. Our assumption is derived from the fact that some of the rules and provisions are closer aligned to the activities of big banks, while other rules and regulations relate more to the activities of small banks. Some of the proposed rules that define the Dodd-Frank Act will be discussed in the next section.

The Dodd-Frank Act is an important topic for further research not only because it can dramatically alter the financial landscape for the banking industry, but we believe that it also causes indirect effects to individuals in society as well.Hypothetically speaking,a provision from the Dodd-Frank Act can restrictthe ability for a bank to generate income in a certain revenue stream. Due to the restriction, the bank might need to cut costs to compensate for the loss in revenue. Cost cutting ultimately gets passed down to the customers of the bank, either through increased fees or elimination of services. Looking at the big picture, thecompliance of thousands of different banks in the U.S. with the Dodd-Frank Act would indirectly affect a large population of bank customers.Some of the questions we attempt to address in our analysis are as follows:(1) What impacts will the Dodd-Frank Act have on earnings, return on equity, return on assets, and other performance ratios for companies? (2) Does the Dodd-Frank Actimpose regulatory costs on all companies equally, or disproportionally? We hope that the results from our paper can provide for policymakers, regulators, and academic scholars a better understanding of the Dodd-Frank Act and valuable guidance for future decisions regarding financial regulation.

The remainder of the paper is organized as follows. Section 2 presents background information and overview of the Dodd-Frank Act. Section 3 discusses the related literature pertaining to the impact of regulation on the profitability of financial firms. Section 4 presents the motivation for our paper as well as the development of the hypotheses. Section 5 presents the data collection, and the methodology used. Section 6 reports on the empirical results and findings. Section 7 discusses our robustness test results. And lastly, Section 8 concludes our paper.

2. Background and Motivation

2.1 Dodd-Frank: Brief Overview

On July 21, 2010, U.S. President Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (thereinafter referred to as “Dodd-Frank” or “the Dodd-Frank Act”) into law.This landmark legislation was dubbed the most significant overhaul of the U.S. financial system since the Great Depression. The Act, which was first proposed and referred in the House Committee on Financial Services and the House Oversight and Government Reform in December 2009, is named after U.S. Senator Chris Dodd and U.S. Representative Barney Frank for their creation and significant contribution to the passage of the Act.^[1] It was drafted in direct response to the main problems and concerns that caused the 2008 Financial Crisis.

The Dodd-Frank financial reform law is very complex and comprehensive in both depth and scope because it deals with virtually many components of the U.S. financial system. It contains many provisions (16 titles in total) that relate to the oversight and reform of derivatives, hedge funds, insurance, mortgages, investor protection, and other requirements. However, due to the overwhelming length of this detailed regulation, we will highlight the most important aspects of the Dodd-Frank Act and will only focus on a number of significant issues for the purpose of this research paper.

Under the Dodd-Frank Act, new government agencies were established to address the regulatory gaps and oversight failures that had occurred during the housing bubble and the subsequent Financial Crisis of 2008.The events surrounding the government bailout of AIG and the collapse of Bear Stearns and Lehman Brothers gave meaning to the term, “too big to fail”. “Too big to fail” is the idea that a business has become so large and so ingrained into the economy that a government will step in to provide assistance (i.e. bailout) to prevent its failure.Any failure of a “too big to fail” firm might have a ‘contagion effect’ that may become widespread and cause problems to the rest of the economy.During the Financial Crisis, those fears prompted the U.S. government to bail out those institutions that were deemed ‘systemically important.”Unsurprisingly, the U.S. taxpayer-funded bailout for “too big to fail” firms was highly controversial and was widely met with disapproval by many people who deemed it unjustified. The “too big to fail” designation raised the concern of whether or not it would create an environment conducive to moral hazard behavior.

For that matter, the Financial Stability Oversight Council (“FSOC”) and the Orderly Liquidation Authority (“OLA”) were created to identify, manage, and monitor systemic risks to the U.S. economy posed by the products and activities of large, complex, and interconnected financial and non-financial institutions. Accordingly, these companies whose total consolidated assets are equal to or greater than $50 billion dollars are labeled “systemically important financial institutions” (“SIFI”).They are increasingly subjected to more stringent standards in terms of risk-based capital, liquidity, leverage, and other requirements than other institutions. These standards also include contingent capital requirements, short-term debt limits, enhanced public disclosures, a risk committee requirement, a stress test requirement, and a maximum leverage ratio^[2].

Additionally, large complex companies will be required to periodically submit “living wills” to regulators in the event of financial distress.“Living wills” serve as a roadmap for how a company should be rapidly and orderly wind down in the event of a failure. The Council and the OLA are empowered with the ability to liquidate, restructure, or break up failed or bankrupted institutions that pose serious adverse effects to the stability of the financial system.Simply put, the duties of the FSOC are to (1) promote market discipline by eliminating expectations of future government bailouts (2) maintain investor confidence, and (3) enhance the integrity, efficiency, competitiveness, and stability of the U.S. financial markets^[3].

One of the main arguments for the reason that led to the U.S. housing crisis was the abusive business practices that had occurred in the subprime lending marketplace.For example, during the housing boom banks would offer low or no documentation loans (i.e. “liar loans”) at zero interest rates (i.e. “teaser rates”) in order to encourage borrowers to take out loans to purchase houses. Eventually, the housing bubble collapsed as both borrowers and lenders were blamed for their speculative and reckless behavior. The problem was dually exacerbated by lenders who were incentivized to generate revenue from the mortgage applications without proper due diligence about borrowers’ credit histories, and borrowers who took advantage of the low interest rate environment opportunity to “flip houses.” Under the Dodd-Frank Act, a new regulatory agency was formed to address this issue: The Consumer Financial Protection Bureau (“CFPB”) is tasked with overseeing various types of financial products and services offered to American consumers and businesses. Its purpose is to protect and better serve consumers from predatory mortgage lending, hidden fees, abusive terms, and deceptive practices by requiring more transparency and disclosure. For example, credit card companies and consumer lenders would be required to disclose terms that are easier to understand for consumers. The Durbin Amendment, which caps the fees banks can charge merchants for debit card transactions (i.e. interchange fees), is also included in this provision.

In the aftermath of the Financial Crisis, it was revealed that the three biggest credit rating agencies, namely Moody’s, Fitch, and Standard & Poor’s (“S&P”), gave inaccurately high ratings to U.S. residential mortgaged-back securities (“RMBS”) and collateralized debt obligations (“CDO”) that severely distorted and misrepresented the risk profile of those securities. In turn, this naturally led to risk mismanagement by investors, market participants, and financial institutions.For example, although AAA-rated securities have historically had less than 1% probability of incurring defaults, over 90% of the AAA ratings given to subprime RMBS securities that originated in 2006 and 2007 were later downgraded by the Nationally Recognized Statistical Rating Organizations (“NRSROs”) to junk status^[4]. The failure arose from the conflict of interest between the rating agencies and the bond issuer. The “issuer-pay model” involved the bond issuer paying the rating agencies to have their bonds rated. Naturally, it was in the best interests for the rating agencies to give favorable ratings for the bond issuers in order for them to gain more business dealings. Thus, the agency problem of ratings agencies being compensated by the same companies whose securities they rate was a very serious issue. It caused many institutions to write-off bad loans during the Crisis of 2008 once they found out that the AAA-rated securities were, in fact, incorrectly rated.

The Office of Credit Ratings was created by the SEC to improve the transparency, accountability, and accuracy of rating agencies in several ways. For one, NRSROs would be required to offer full disclosure of their ratings methodologies, their ratings track record, and any initial or revised credit ratings issued.Congress finds that “…the activities and performances of credit rating agencies, including nationally recognized statistical rating organizations, are matters of national public interest, as credit rating agencies are central to capital formation, investor confidence, and the efficient performance of the United States economy.”^[5] Given the vital role that the credit rating agencies play in the financial markets, it is important that their actions do not undermine the integrity of the U.S. financial system and erode investor confidence. Investors and market participants depend on the ratings given by the rating agencies to make prudent and sound financial decisions.

Much of the heavy losses surrounding the banks during the Financial Crisis involved them engaging in speculative trading. For mostly investment banks, a substantial amount of their revenue comes from trading. As noted by Bloomberg, “…The six largest U.S. banks made $15.6 billion in trading profits during 13 of the 18 quarters that spanned mid-2006 to 2010.”^[6] However, a bad bet can be the difference between a “make or break” for banks. The most recent example of a speculative trade gone awry was the London Whale scandal that saw a $6.2 billion dollar loss at JPMorgan Chase by a single trader in 2012. Other trading losses include SocieteGenerale ($5.9B) in 2008 and UBS ($2.3B) in 2011. Because of situations like these, the Volcker Rule, named after the former Fed Chair Paul Volcker, intends to prohibit banks from engaging in proprietary trading of securities, derivatives, commodity futures and options, and impose limits on investment in and sponsorship of hedge funds and private equity funds with their own accounts. The Rule’s purpose is to rein in banks’ risk-taking activities and speculative investments that do not benefit their customers. However, exemptions from the Volcker Rule were allowed regarding activities such as market making, underwriting, hedging, trading in government securities, hedge funds and private equity offerings, and acting as agents, brokers, or custodians.Large financial institutions are required to meet and implement compliance programs and are subjected to reporting of trading activities to the government.

2.2 Dodd-Frank: Recent Update

The Dodd-Frank Act has two clear objectives: limiting the risk of the shadow banking system by more carefully regulating derivatives and large institutions; and limiting the damage caused by a financial institution’s failure (Skeel, 2010).Covering well over 2,300 pages in length that includes 398 required rules and regulations, to say that the Dodd-Frank Act is complex is a gross understatement. Based on a progress report published by the law firm Davis Polk, only 52.4% (208) of the total 398 rule-making requirements have been met so far as of July 2014.More specifically, out of 280 rulemaking deadlines that have passed, 45.7% (127) of them have been missed by regulators and 54.3% (152) have been met with finalized rules (Davis Polk).Therefore, much work is still left to be done in the areas of asset-backed securities, credit rating firms, derivatives and mortgage reforms.

As their mission statement reads, the Dodd-Frank Act’s objective is to “promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail’, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.”^[7] What’s more, it is purported to “increase investment and entrepreneurship, foster competitiveness, confidence in our financial sector, and robust growth in our economy” as well as “bring greater economic security to families and businesses across the country.”^[8] Congress has given regulators much of the power in terms of the rule-making process, since the Dodd-Frank Act was only considered to be a regulatory framework or guideline to be built upon.

Many banks are wary that the Dodd-Frank Act would have adverse effects on their business operations. In response, they are becoming cautious in the hiring of new employees citing regulatory environment uncertainty. Preliminary evidence suggests that the financial regulatory reform seems to have negatively impacted businesses already. For example, in a testimony to the House Financial Services Committee on July 23, 2014, Dale Wilson, CEO of the First State Bank of San Diego, argued that small community banks such as his have encountered tough challenges due to “excessive regulation” from Dodd-Frank.^[9] He noted that many small banks have exited the mortgage business, citing high risks and high costs of compliance that hinder their abilities to better serve the rural community. “The real costs of the increased regulatory burden are being felt by small town borrowers and businesses that no longer have access to credit,” Wilson claimed.

A recent publication by the American Enterprise Institute adds to our understanding of the importance of community banks: They provide 48.1% of small-business loans issued by U.S. banks, 15.7% of residential mortgage lending, 43.8% of farmland lending, 42.8% of farm lending, and 34.7% of commercial real estate loans (Marsh & Norman, 2013).Small businesses are disproportionately impacted by the enormous regulatory costs due to diseconomies of scale compared to their larger counterparts.According to a statement by the House Financial Institutions Subcommittee, “the regulatory burden is preventing new community banks from forming. No new community bank charters have been granted since 2011, due in part to the regulatory burden of Dodd-Frank” (Carney, 2013). If this is true, it could mean dire consequences for the U.S. economy as the statistics above show the importance that small banks have in the U.S. financial system.

Restrictions on proprietary trading could cost billions of dollars annually in lost revenue in addition to a weakened financial system by raising borrowing costs (Ives, 2012). Studies have also found that banks have cut $70 billion dollars in credit cards in the face of tightening underwriting standards and higher required capital ratios, affecting low-income consumers (McCloskey, 2013). Due to the compliance costs of Dodd-Frank, many banks have increased their fees or eliminated some of their services altogether. According to Bankrate, 76% of banks offered free checking accounts in 2009 compared with 39% in 2012. The dramatic decrease will undoubtedly shift consumer behavior as people might consider other alternatives for their banking services needs.

The U.S. Government Accountability Office (“GAO”) reported that the implementation of Dodd-Frank will cost the federal government as much as $2.9 billion over five years, with the first year estimated to cost around $974 million (McGrane, 2011). The real impacts felt by financial institutions are still fervently debated among regulators, policymakers, and academic scholars alike. Since the implementation of the Act is relatively recent, there is a dearth of literature currently available that study the impact of Dodd-Frank on the profitability and performance of commercial and savings institutions.

In a separate study, Peirce and Broughel (2014) noted that “with its numerous and incomprehensible complexities, Dodd-Frank gives big banks a competitive edge over their smaller rivals, who are less able to hire the lawyers and compliance personnel necessary to advise on complying with the law in the most cost-effective manner.” With more extensive networks and deeper pockets, big banks can hire the expertise necessary to navigate through the complex financial regulations. They also found that small banks are worried about the Consumer Financial Protection Bureau (“CFPB”) and new mortgage rules. And they have reason to be because, as mentioned earlier, the CFPB caters to small individual consumers and businesses, which is the main customer base for small banks. Meanwhile, Gao et. al (2011) provided empirical evidence on the economic impact of Dodd-Frank by examining stock and bond market reactions to its passage.The findings suggest that large financial institutions had lower idiosyncratic risk and systemic risk in the period after the passage of the Act compared to the period before. Moreover, large financial institutions overall had negative abnormal stock returns and positive abnormal bond returns.

The first aforementioned preliminary study on Dodd-Frank serves as a motivational point for our research paper.We hope to contribute to the literature on the impact of financial regulations on firms by extending the study done by Pierce, Robinson, and Stratmann (2014). Instead of conducting a survey, we will attempt to provide empirical evidence relating to the effects of the Dodd-Frank Act on the performance publicly listed commercial and savings institutions in the U.S.

3. Literature Review

3.1 Financial Regulation and Firm Performance

Regulation of the financial markets has always been a subject of debate, with both advocates and critics of regulation proposing valid viewpoints. The pro-regulation side believes that the marketplace would be more efficient and stable with government intervention.What’s more, empowering the government to regulate the financial markets would encourage market confidence, consumer protection, and financial stability.The pro-deregulation side, however, argues that the government is less knowledgeable than businesses themselves in deciding what is in the businesses’ best interests. They also claim that deregulation would create a more efficient market since increased competition would benefit consumers by driving down costs and increasing choices. One example of financial regulation in the U.S. was the Glass-Steagall Act of 1933, which was signed into law in the aftermath of the Great Depression^[10]. The Glass-Steagall Act separates the activities of commercial banks and investment banks. The impact of regulatory reform extends well beyond firms and financial institutions: Since regulation affects the business activities of companies, and thus its profit margins, the effect would inevitably be passed down to investors, consumers, and other market participants. If regulation is the proper approach, how much regulation is sufficient? For what types of activities should regulation be imposed? How should regulation be enforced? And how are certain firms and institutions impacted by financial regulation?

Large bodies of literature exist that try to shed light on the issue of regulation. Aivazian, Ding, and Rahaman (2013) study the effects of financial regulation on firm performance. They find that firms that are more reliant on external capital markets for financing and more financially constrained are disproportionately subjected to greater costs during credit contractions: In addition, decline in sales, investment, and inventory growth are greater for those aforementioned firms situated in “ex-ante repressively regulated financial markets.” Barth, Caprio Jr., and Levine (1999) provide further evidence through their cross-country study of financial regulation and performance. They report a positive statistically significant relationship between the degree of regulatory restrictiveness—i.e. securities activities of banks—and banking sector fragility.However, the results are mixed regarding the relationship between the degree of regulatory restrictiveness and banking sector efficiency. Furthermore, they find that the impact of regulatory restrictions on bank performance is also mixed.

In an updated study, Barth, Caprio Jr., and Levine (2001a) confirm that diversification of income streams—by not restricting bank activities—are positively linked with bank performance and stability.Greater restrictions, it seems, are associated with a higher probability of suffering a majoring banking crisis and lower banking-sector efficiency (Barth et al., 2001b). Similarly, a follow-up paper by the same authors further provide evidence that restricting bank activities is negatively associated with bank development and stability (Barth et al., 2004). The understanding of this relationship is pivotal since bank development is positively correlated with economic growth.Furthermore, strengthening government oversight of banks is ineffective in reducing bank overhead costs (Barth et al., 2007). In his most updated research, Barth et. al (2013) contributes to the bank regulatory literature by examining the relationship between bank regulation, supervision, and monitoring on bank operating efficiency. Utilizing a panel data 4,050 bank observations in 72 countries, their findings show that tighter restrictions on bank activities are negatively correlated with bank efficiency. Meanwhile, more stringent capital regulation is positively associated with bank efficiency.

Demirguc-Kunt, Laeven, and Levine (2004) examine the influence of bank regulations and concentration on bank margins and overhead expenditures utilizing a cross-section of countries as their sample data, while controlling for differences in bank-specific factors and cross-country macroeconomic factors. The main findings are as follows: (1) Tighter regulatory restrictions are associated with bigger net interest margins, controlling for banking sector concentration, bank-specific characteristics, and the rate of inflation. (2) No significant positive link between concentration and efficiency, controlling for regulatory restrictions. Lastly, in a research concept similar to our paper, Primack (2012) studies the financial impact of the Sarbanes-Oxley Act (“SOX”) on different sized U.S. public companies.^[11] Heconcludes that smaller companies disproportionately bear the majority of the regulatory costs as opposed to larger companies. The author looked at auditor fees and earnings over the period 2000-2010 and found that SOX raised the average auditor fees by 43% for a 15th percentile firm and 23% for an 85th percentile firm by market cap, compared to their pre-SOX levels.

Pelster, Iresberger, and Weiss (2014) examine the effects that bank capital, regulation, and supervision had on banks’ stock performance. Their analysis uses a panel dataset of 1,659 international banks from 74 countries over a four year time period (1999-2012). They find that higher regulatory capital, in the form of Tier 1, is negatively related to banks’ stock performance. More specifically, they conclude that bank stock returns are significantly lower for larger banks that are more likely to receive a government bailout.Rezende and Wu (2014) estimates the effects of supervision on bank performance using discontinuities in the minimum frequency of examinations required by regulation. They conclude that more frequent examinations are associated with an increase in bank profitability due to a decreasein loan losses and delinquencies.Neyapti and Senel (2008) study how prudent bank regulation and supervision influence economic growth. They discover that higher regulation and supervision standards correlate with higher per capita output, wages, credit, and lower interest rates. Furthermore, greater supervision result in higher bank profitability.

Curbing excessive risk-taking by large financial institutions and banks was the one of the main objectives of the Dodd-Frank Act. How will these banks react in the face of strict regulation governing their risk appetite?Ongena, Popov, and Udell (2013) explored this question in their most recent paper. They provide empirical evidence that bank regulation is associated with cross-border spillover effects through the lending activities of large multinational banks. In summary, the authors find that higher home-country restrictions on bank activities coupled with higher home-country minimum capital requirements lead to the greater likelihood that banks would search for risks abroad by lowering their lending standards.

3.2 Bank Concentration, Capitalization, and Profitability

There are large bodies of theoretical and empirical literature that argue about the effects of bank concentration on banking sector fragility. Some believe that higher bank concentration will lead to more instability while others believe it to be more stable. Thus, it is important to comprehend the ramifications that the Dodd-Frank Acthas on bank concentration.In the “concentration-fragility” vs. “concentration-stability” argument, Beck et. al (2006) concludes that crises are less likely in more concentrated banking systems, while fewer regulatory restrictions on banks reduce bank fragility. Allen and Gale (2004) find that less concentrated banking sector with many small banks is more prone to financial crises than a concentrated banking sector with a few large banks. Anginer, Demirguc-Kunt, and Zhu (2014) analyze whether greater banking competition led to more stability in the banking system. They assert that there is a robust negative relationship between bank competition and systemic risk.The underlying reason points to the fact that greater bank competition encourages banks to take on more diversified risks, which thereby lower the overall systemic risk.

A previous study confirms that a positive relationship exists between capitalization and profitability, and a negative relationship between reserves and profitability (Demirguc-Kunt and Huizinga, 1999). Furthermore, they find that “the bank concentration ratio has a significant and positive impact on bank profitability, while bank size, as proxied by total assets, has a significant and positive impact on interest margins only.”Shrieves and Dahl (1992) investigates the relationship between the changes in risk and capital in banks and find a positive association. Bank managers have an incentive to lower their risk exposure by ensuring that the bank’s capital ratios exceed the regulatory minimum.

Mbizi (2012) observed the impact of capital requirements on commercial bank performance in Zimbabwe. According to the paper, “the major reasons for bank capital regulations are to maintain bank safety and soundness, protect bank creditors and depositors in the event of a bank failure, and to create a disincentive to excessive risk taking by banks and provide a buffer against losses.” The paper claims that bank performances are affected by bank capitalization, with high capital levels leading to better bank performances (i.e. profitability).Scholtens (2000) analyzes the relationship between competition, growth, and performance in the banking industry. Specifically, he tests for whether the size of banks matters for bank profit performance. Scholtens concludes that bank profits are inversely related to the amount of bank assets and are positively correlated with the amount of Tier 1 bank capital. The findings have important implicationsand can be extended to our paper.

Naceur and Goaied (2008) investigate the impact of bank characteristics, financial structure and macroeconomic factors on banks’ net interest margins and profitability in the Tunisian banking industry for the period 1980-2000. Their principal findings suggests that (1) size has a significantly negative coefficient on bank profitability and (2) individual bank characteristics explain a significant portion of the variation in bank interest margins and net profitability.In a previous paper, Naceur and Kandil (2009) study the impact of capital regulations on the performance of Egyptian banks. With performance measured by cost of intermediation and profitability (i.e. ROE/ROA), it concludes that higher capital to assets ratio, a reduction in inflation, and an increase in banks’ size positively contributes to banks’ profitability in the post-regulation period. One of the earliest literatures that analyze the association between bank size and bank profitability was Gallick (1976). The focus of his data is U.S. commercial banks between the years 1954-1974. At the same time, he acknowledges that other factors might explain variability in bank profitability: location, bank structure, asset portfolios, and quality of bank management. His paper finds that there is a tendency for rate of return on capital to increase from an increase in bank size. Shehzad, De Haan, and Scholtens (2013) investigate the interaction between bank size, growth and profitability for more than 15,000 banks from 148 countries from 1988-2010. They come to the conclusion that in Organization for Economic Cooperation and Development (OECD) countries such as the U.S., big banks exhibit slower growth but are more profitable than small banks. Additionally, bank profitability is constant while bank growth was not. Their findings have useful implications for our own research.Stricter regulations on capital requirements and bank activities have a negative impact on profit efficiency, but a positive one on cost efficiency based on a paper by Pasiouras, Tanna, and Zopounidis (2009).Their study includes a panel dataset of publicly listed commercial banks in 74 countries for a timeframe of 2000-2004.Seiford and Zhu (1999) examine the profitability and marketability of the top 55 U.S. commercial banks. They come to the conclusion that “relatively large banks exhibit better performance on profitability, whereas smaller banks perform better in marketability.”

Behr, Schmidt, and Xie (2009) discuss the effect of capital regulation on the risk taking behavior of commercial banks, controlling for different bank concentration. With a panel dataset that includes 421 commercial banks from 61 countries, only in a low degree of concentrated markets do they find that capital regulation is effective in diminishing risk taking by commercial banks.Blum (1999) argues that capital adequacy requirements may increase bank risk-taking. Relating to the effect of bank capital on financial stability, Thakor (2014) provides empirical evidence based on a cross-section of banks that higher capital is associated with higher lending, higher liquidity creation, higher bank values, and most importantly, higher probabilities of surviving crises. On the same note, lower capital in banking leads to higher systemic risk and a higher probability of a government-funded bailout.In a recent paper, Ayadi (2014) analyzes the impact of capital regulation on the European bank performance. The author finds that bank capital requirements are negatively related to both bank performance and risk-taking. The panel data study was done over the period 2004 to 2009. However, it might not be a good idea to extend the results of that paper to our analysis due to the difference in the time period chosen.Bostandzic, Pelster, and Weiss (2014), in a recent paper, study the effect of bank capital, regulation, and deposit insurance on the systemic risk exposure for large international banks during the period 1999-2012. They identify that higher Tier 1 capital decreases both the exposure and contribution of individual banks to global systemic risk. Furthermore, results show that bank size and interconnectedness are positively related to global financial fragility. This literature relates to the “concentration-fragility” theory, which submits that higher banking concentration increases the fragility in the financial system.

3.3 Financial Leverage, Capital Ratio, and Risk

Financial leverage and capital ratio are two important proponents describea bank’s appetite for risk or its exposure to risk. Leverage can be defined as the amount of debt used to finance a firm’s assets. Banks utilize leverage to generate a higher amount of revenue.However, under the weight of heavy debt loads, banks also increase their likelihood of having insolvency issues. Capital ratio is similar to financial leverage in that regulators use both ratios as yardsticks to measure for bank solvency and bank performance. The relationship that financial leverage and capital ratio has on bank performance are studied extensively in literature.

Wolff and Papanikolaou (2010) study the relationship between leverage and risk for U.S. commercial banks in a panel data set covering years 2002 to 2010. They find that excessive leverage was a primary factor in the liquidity shortage that plagued the big banks during the Financial Crisis. More importantly, their results reveal that banks that engage in traditional banking activities have less risk exposure than to those who are involved with complex derivatives. Since it is the big banks that are typically associated with complex derivatives, they carry more risk than small banks. This claim can be confirmed by a recent study examining the association between bank size and systemic risk. Laevenet. al (2014a) argue that big banks create more systemic risk to the financial system when they are structurally complex. The regulators who advocate the Dodd-Frank Act argue the same premise.

After the Financial Crisis, regulators came to realize that the largest banks in the U.S. financial system posed serious systemic risks. The fact that many of those banks were interconnected to so many other institutions was worrisome. The global liquidity crunch and economic havoc in 2008 became a primary topic of research for scholars interested in how the Financial Crisis unfolded and how bank performance was affected surrounding those events.Laevenet. al (2014b) find that the relationship between bank size and systemic risks is positively related. On the other hand, systemic risk and bank capital is inversely related. Other literature observes how bank capital affects performance: Demirguc-Kuntet. al (2013) test to see whether better capitalized banks had higher stock returns during the Financial Crisis. They find that during the crisis, higher capital resulted in better stock performance for big banks and less well-capitalized banks.

4. Hypothesis Development

Regulations have the potential to affect the financial performance of firms and corporations, or more accurately, their cost and profitability measures.Stricter regulatory reforms can come in the form of increased capital requirements, higher liquidity ratios, restrictions on certain bank activities, compliance costs, etc.Our argument for this paper is that Dodd-Frank Act’scomplex regulatory reforms willhamperU.S. listed commercial and savingsbanks’ ability to generate revenue as well as add to their cost burden.It would impedeon revenue generation because of bank activity restrictions. Another way to think about is that those same restrictions would inhibit diversification of risk as well. Stricter regulatory reforms would add more cost burdens to banks in the form of compliance staff hiring.Compliance personnel arevalued for their services to understand, interpret, and ensure that banks abide by the Dodd-Frank Act. The Act has 16 provisions and countless other regulatory details that banks would have to abide by. Some of the rules pertain to large banks and some to small ones, owing to the different markets that different sized banks serve. The massive regulatory overhaul of the Dodd-Frank Act is far-reaching in its oversight of many aspects of the financial system, as discussed in the introduction to this paper.

Our motivation for this paper comes from several sources. First of all, there are an abundance of online articles and financial pundits that have weighed in on the potential impacts of the Dodd-Frank Act, so this widely politicized issue really piqued our interest. Secondly, this regulation will affect the entire financial community for many years to come.However, only half of the proposed rules have gone into effect, not to mention the headwinds that regulators have to face from the lobbying efforts of the banking industry to thwart or at least minimize the damageof the regulation. Thereby, our goal is to provide valuable insight and extend the existing literature by utilizing Dodd-Frank as an object of research for the implication that financial regulation has on the performance of U.S. listed commercial and savings institutions.

Many companies have acknowledged the challenging business environment due to the operational and compliance costs associated with Dodd-Frank. Small community banks fear that the “overregulation” would negatively impact their businesses more than their larger competitors. This is important as the customer base and niche markets that small banks serve are greatly different, not to mention more important, from those of the big banks.As compliance costs mount up due to regulatory headwinds, smaller banks have had to consolidate with bigger banks and to an extreme degree, even go out of business. Recent evidence shows that the number of small US banks has markedly decrease by 24% from 2000-2013 while big US banks has increased by 29% in the same period, as illustrated in Figure 1 in the Appendix.Furthermore, the graph from Figure 2 reveals that the passage of Dodd-Frank has negatively affected the number of small banks, small banks’ share of US banking assets, and small banks’ share of domestic deposits. Based on the data provided, the assumption seems to be that to some extent, financial regulation(i.e. “Dodd-Frank”) might have a significant impact on the operation and profitability of small US banks.

One of the primary reasons why the Dodd-Frank legislation was introduced was to resolve the issue of too-big-to-fail (“TBTF”) and to rein in excessive risk-taking activities by the big banks. Therefore, the framework of Dodd-Frank was primarily built with the big banks in mind since much of the blame surrounding the housing crisis involved subprime lending and complex derivatives operationsthat were mostly conducted by large financial institutions.According to a recent study by the New York Fed, large US banks benefits from lower borrowing and operating costs compared with smaller ones, which might reflect the possibility that “investors believe the U.S. government would again rescue them in a panic” (Reuters). If this statement is true, then market discipline will not be enforced on the too-big-to-fail institutions due to the guarantee of ‘safety nets’ by the government.Instead of making the financial system safer, this creates an environment that condones moral hazard.

To assess the impact of the Dodd-Frank Act on commercial and savings banks, we first examined the notes in a bank’s 10-K annual report. Usually, a company will mention and bring attention to any significant news or events that might impact a firm’s business operations. We looked at the financial statements for small banks and big banks.For both big banks and small banks, some of the bank operations that are affected by the Dodd-Frank Act include, but are not limited to (1)limiting the debit card interchange fees that banks can charge to vendors, (2) banning proprietary trading and restricting investments in hedge funds and private equity funds, (3) imposing additional capital and margin requirements for derivative market participants, among others. Restrictions on bank activities put pressure on the profitability and bank performance of all banks alike.Following both Demirguc-Kuntet. al (1999) and Naceur and Kandil (2009) who conclude that bank size has positive significance on profitability, we predict that the performance of big banks would outperform small banks following the Dodd-Frank regulation.In other words, we expect to see small banks more negatively impacted than the big banks. Based on these reasons and recent evidence, we present the following two hypotheses:

Hypothesis #1:

H1: The Dodd-Frank Actwill impact bank performance

Hypothesis #2:

H2: The Dodd-Frank Act will more negatively impact the performance of small banks than that of big banks

5. Data and Methodology

5.1 Data Collection

Our data was downloaded and retrieved from the Compustatdatabase and Bank Regulatory database accessed from the Wharton Research Data Services (WRDS).Compustat is an online database consisting of reliable financial, statistical, and market information for conducting research. The Bank Regulatory Database is a dependable source of information that provides financial accounting data on regulated depository financial institutions such as commercial banks, savings banks, bank holding companies, and savings and loans institutions.In addition, other outside databases such as the World Bank Data and the Federal Reserve Economic Data (FRED) were utilized. The World Bank Data provides data about the development in countries around the world. Some of the relevant indicators it offers include GDP growth, GDP per capita, Inflation, Foreign Direct Investment, and many others. The Federal Reserve Economic Data is an online database that provides economic data that is sourced from national, international, public, and private entities. Similar to the World Bank Database, the FRED provide key government statistics including employment data, exchange rates, federal government debt, interest rates, and many others. Lastly, Bloomberg Terminal was used to verify and fill in any missing data observations. Micro level data were collected from Compustat as well as from Bank Regulatory in WRDS. Macro level data were collected using World Bank Data and the Federal Reserve Bank of St. Louis’ Economic Data. The appropriate databases were chosen for both micro level and macro level data according to their data accessibility.

As our research is focused solely on commercial and savings banks publicly listed in the U.S., we specified our searchfor sample firms based on two SIC Codes- 6020 (i.e. Commercial Banks) and 6035 (Savings Institutions).SIC is a system of classifying industries based on a 4 digit code. It should also be noted that the criteria for publicly listed commercial and savings banks in the U.S. also included those that are listed in over-the-counter (OTC) exchanges. Securities that do not meet exchange listing requirements for main, centralized exchanges are relegated to OTC markets. Originally, after entering the SIC codes and selecting the desired inputs into WRDS, the output for our panel data covered675 firms over the period from 1st quarter 2005 until 2ndquarter 2014. The fiscal years, 2005 and 2014, were chosen to allow for sufficient ex-ante observations prior to the introduction of Dodd-Frank and ex-post observations afterwards, accounting for data availability.In other words, we gathered quarterly data over a span of ten fiscal years. Therefore in total, there were 20,623 observations in our sample initially.

However, we decided to eliminate some firms that exhibited categorical changes from small bank to big bank or vice versa at any time throughout the period 2005-2014. The threshold to differentiate between big banks and small banks will be discussed in the next section of this paper. The reason for taking such measures is to ensure that we get cleaner data to observe the pure effects of small banks and big banksperformance and to avoid confounding effects. A confounding effect can cause problems by distorting the relationship between the independent and dependent variables. The initial Compustat output included commercial and savings banks that were listed in foreign countries’ stock exchanges, so we also had to clean our data for that.Additionally, we deleted sample firms that didn’t meet the requirements necessary for our research due to insufficient observations. Finally, there were a total of 640 commercial and savings banks after elimination, with 19,355 observations.Lastly, before moving forward we are aware that our sample firms may suffer fromsurvivorship bias due to the likelihood that some inactive firms were delisted from the exchanges because of bankruptcy, failure in listing requirements, and other issues.

5.2 Variables Specification

5.2.1 Dependent Variables

There are many ways to measure or value bank performance. Berger and Bouwman (2012) use return on equity to analyze the impact of capital on the performance in banks during the Financial Crisis. Rezende and Wu (2014) use net interest margin as a percentage of total loans and return on equity as a bank performance measure. In our analysis, we usethree performance metrics in order to grasp the impact of the Dodd-Frank regulation on U.S. listed commercial and savings banks: Net Interest Margin (NIM), Return on Assets (ROA) and Return on Equity (ROE).Net Interest Margin (NIM) is defined as the interest income minus interest expense divided by the total interest earning assets, specified as a percentage. The net interest margin is a determinant of bank profitability because it measures the spread between the loan and deposit rates. Return on Assets (ROA) is defined as the current quarter’s net income (loss) divided by previous quarter’s total assets.It is a profitability ratio that reflects how well firms generate income from their invested capital (assets).Return on Equity (ROE) is calculated as the current quarter’s net income (loss) divided by previous quarter’s total stockholders’ equity.But afterwards, we performed a 99% winsorization on the ROE observations, which set all data from below the 1st percentile up to the 1st percentile. Winsorization is a transformation technique widely used in statistics to limit the influence of outliers. In a winsorized estimator, the extreme values are replaced by certain percentiles (the trimmed minimum and maximum). The return on equity measures shareholder’s return, specified as a percentage. Similar to ROA, the Return on Equity is also a profitability ratio. It determines the rate of return on the money that shareholders invested. We chose these variablesas performance measures because they are widely used in other literature as well (seePelster, 2014; Demirguc-Kunt, 2004; Barth, 2004; Barth, 1999). Even though they show importance as response variables in previous banking regulation literature, we nevertheless use NIM, ROA, and ROE in order to find whether their significances are robust when applied to the study of the Dodd-Frank Act regulation.

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^[1] Bill Summary & Status, 111th Congress (2009-2010), H.R. 4173, All Congressional Actions with Amendments (The Library of Congress: Thomas).

^[2] Morrison &Foerster, “The Dodd-Frank Act: a cheat sheet”

^[3] banking.senate.gov/public/_files/070110_Dodd_Frank_Wall_Street_Reform_comprehensive_summary_Final.pdf

^[4] Commissioner Luis A. Aguilar, “Addressing Conflicts of Interest In the Credit Ratings Industry” (Remarks at the Credit Ratings Roundtable, Washington D.C., May. 14, 2013)

^[5] Dodd-Frank (2010): One Hundred Eleventh Congress of the United States of America https://www.sec.gov/about/laws/wallstreetreform-cpa.pdf

^[6] http://www.bloombergview.com/quicktake/the-volcker-rule

^[7] Dodd-Frank (2010): One Hundred Eleventh Congress of the United States of America

^[8] President Obama, The White House: Office of the Press Secretary, (Remarks by the President on the Passage of Financial Regulatory Reform, July. 15, 2010)

^[9] Wilson, D. “Dodd-Frank Act and Financial Regulatory Policy,” C-SPAN, July. 23, 2014

^[10] The Glass-Steagall Act separated the activities of commercial banking from investment banking. Under a deregulatory environment, it was repealed in 1999 under the Gramm-Leach-Bliley Act.

^[11] Sarbanes-Oxley Act of 2002: An act passed by U.S. Congress to protect investors from fraudulent accounting activities by requiring corporations to improve financial disclosures and through other reforms. The SOX was enacted in response to the accounting scandals in the early 2000s, such as Enron, Tyco, and WorldCom.