We’ve written several times about the plight of smaller banks under the post-crisis regulatory regime of the Dodd-Frank Act. We’ve heard personal accounts from the managements of small and midsized banks about the crushing burden of regulatory requirements. At the end of 2014, we wrote:
“Community banks’ role, though, is mostly more boring -- making mortgages and loans accessible to America beyond the big cities and the two coasts. But legislation aimed at curbing big banks’ excesses is eating them alive. In the two years before Dodd-Frank, more than 50 new regulations affecting small banks went into effect. Dodd-Frank has added hundreds, and will add hundreds more by the time it’s completely implemented.
Those additional rules have costs -- one estimate shows small banks’ compliance costs rising 50 to 200 percent as a result of Dodd-Frank’s regulations. For many small banks, the regulatory burden is simply too great. 1,500 community banks (some 18 percent of the total) have closed over the past 10 years, and Dodd-Frank is accelerating the process. Many community bank owners who did not participate in dubious practices in the run-up to the financial crisis see themselves as being punished for the sins of others. Large banks can withstand the increased compliance costs, but a small bank can be pushed into unprofitability when compliance duties require 15 percent of its staff.
Now, though, relief is in sight. Donald Trump singled out Dodd-Frank’s one-size-fits-all approach as being unfair to smaller banks. The Trump victory has led all financials to rally about 10% since the election (represented in the chart below by the SPDR S&P Financials ETF (NYSE:XLF) -- but regional banks (represented by the SPDR S&P Regional Banking (NYSE:KRE) are up more than 15%.
One effect of Trump’s victory that might come soon is a raising of the threshold for a bank to qualify as a “systemically important financial institution.” Currently at $50 billion, many midsized banks fall under it, and the expense of compliance with stress test has been painful. Raising the threshold would relieve those burdens, allow such banks to return capital to investors instead of spending it on compliance, and perhaps facilitate a wave of mergers.
The way forward for larger financial institutions is less clear under a Trump administration. Although reforms to Dodd-Frank seem certain, Trump played on Main Street hostility to Wall Street during his campaign. A restoration of Glass-Steagall, part of the Republican party platform in 2016, may have been floated by Republicans eager to capitalize on popular resentment -- but it may also be a real legislative goal.
On the other hand, with analysts gradually pricing in a bolus of infrastructure spending, a pickup in growth and inflation, and higher interest rates, the big picture is also improving for large financial institutions.
Investment implications: Small banks have been crushed by regulatory burdens in the post-crisis world -- forced to absorb the costs of complying with Dodd-Frank. The victory of Donald Trump gave them relief, with regional banks rallying strongly in the days after the election. Larger financial stocks have also rallied, but their outlook under a Trump administration is murkier, since the campaign employed anti-Wall Street rhetoric, and the 2016 Republican platform called for the reinstating of Glass-Steagall. We continue to prefer the smaller and regional banks.