Why Dodd-Frank increased banking industry consolidation

The global financial meltdown of 2008 resulted in sweeping reforms to the banking industry in the United States. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ushered in a new era of regulation designed to reduce risk to the American financial system.

Wharton accounting professor Allison Nicoletti believes the legislation also created a singular opportunity to study the effects of regulation on banks. She and fellow researchers Hailey Ballew from Ohio State University and Michael Iselin from the University of Minnesota examine the influence Dodd-Frank had on banking consolidation in their paper titled, “Regulatory Thresholds and Mergers and Acquisitions in the Banking Industry.” Recently, Nicoletti spoke with Knowledge@Wharton about their findings. (Listen to the podcast using the player above.)

Knowledge@Wharton: Could you start by giving us a brief overview of your paper?

Allison Nicoletti: We’re examining how regulations with asset thresholds affect bank acquisition activity. I think everyone is familiar with the idea that the banking industry is highly regulated, but what’s interesting is that some of the regulatory requirements only kick in at certain thresholds, usually in terms of total assets.

In this paper what we’re looking at is the $10 billion threshold in Dodd-Frank. Dodd-Frank was a sweeping reform. There were a lot of new requirements, but at $10 billion there are a few significant ones that greatly increase the compliance costs for banks.

Just a couple of examples would be that now banks have to perform company-run stress tests — assessing their bank’s health in different scenarios. They’re also subject to oversight by the Consumer Financial Protection Bureau. What these additional requirements mean is that banks have additional costs, which will have a negative effect on performance.

What we hypothesize in this paper is that as a result of these additional costs, banks might be incentivized to engage in an acquisition. The reason why that’s a viable strategy is because it allows banks to increase their asset size quickly and, hopefully, grow those income-earning assets.

When performance is negatively affected, banks engage in an acquisition. These fixed costs that are associated with the new requirements are spread over this larger asset base, and that negative effect to performance will be somewhat mitigated. This is what we examine, and what we find is that banks engage in more acquisitions following the announcement of Dodd-Frank, and that banks are willing to pay larger deal premiums following this. So, it’s consistent with banks right around that threshold increasing their demand for acquisitions.

Knowledge@Wharton: What would you say are some of the key takeaways for regulators from this data?

Nicoletti: When writers are [formulating] these different regulatory requirements, they’re determining whether all banks should be subject to this, or should we only have banks above a certain threshold subject to these requirements? What we’re showing in this paper is that this is something they should take into account when they’re figuring out whether they layer in multiple requirements at one asset threshold.

Another potential avenue would be in assessing the overall effectiveness of banking regulations. We can’t really speak to that in this paper, but regulators who are typically concerned about consolidation should be aware of this issue.

Knowledge@Wharton: How would you say your study stands apart from other research on this topic?

Nicoletti: There really hasn’t been anything done, at least that we’re aware of, as far as bank responses to asset thresholds. There is a little bit of research on non-financial firms, and typically what these papers look at is whether firms take actions to try to stay below the threshold when a new regulation is passed. In this paper, we’re showing that some banks want to continue growing, and as a response they might engage in an acquisition — which is a different response to the regulations than prior research has shown. Also, you can’t necessarily generalize results from a non-financial study to banks because they’re very unique and have different features.

“We’re showing that some banks want to continue growing, and as a response they might engage in an acquisition — which is a different response to the regulations than prior research has shown.”

Knowledge@Wharton: Would you say that Dodd-Frank presented a unique moment in time in terms of your ability to examine this problem?

Nicoletti: I think it definitely is. There are obviously a lot of different banking regulations that have passed over time, but the banking industry went through a pretty significant change in the 1990s as far as its ability to engage in acquisitions across state lines because prior to that, they weren’t allowed to do that. With Dodd-Frank we have … a bunch of requirements that kick in around these different asset thresholds, and the acquisition activity is a lot more prevalent these days.

Knowledge@Wharton: It’s a perfect environment to study.

Nicoletti: Exactly. Yes, Dodd-Frank did come out of the financial crisis, which makes it a little bit tougher for us, but it provides a really nice opportunity.

Knowledge@Wharton: Would you say overall this is a net positive or a net negative regulatory change?

Nicoletti: At this point, we can’t completely answer that question, but that’s where we’re headed. Our next steps will be to look at the characteristics of the target banks that these banks right around the threshold are acquiring, and also look at what potentially some of the consequences of the mergers are. I think that will be able to provide us with a little bit more insight into whether it seems like this is spurring on a net positive or a net negative behavior.