Big banks, medium banks and why the distinction really matters

A recent Wall Street Journal article addressed one of the tougher questions related to reforming the Dodd-Frank Act enacted in 2010 – the minimum size, in terms of total assets, of a large bank at which point it becomes subject to “enhanced supervision and prudential standards” enforced by the Federal Reserve.

Dodd-Frank established $50 billion as the critical threshold when banks become subject to that increased government oversight.  

{mosads}Enhanced supervision encompasses tougher rules on capital, liquidity, mergers and stress testing, which together are intended to ensure that large banks survive a financial crisis.  However, complying with enhanced supervision is costly to the banks subject to it, which is why there is a strong push among large banks to raise the $50 billion threshold. 

The key public-policy challenge is determining the appropriate level for a higher limit — should it be raised to $100 billion or pushed even higher, to $250 billion, or more? 

Based on Federal Reserve data, at year-end 2016, there were seven banking companies with total assets in the $50-$100 billion size range, 22 in the $100-$250 billion size range, and 12 with more than $250 billion in assets.  The largest banks, each with more than $2 trillion of assets, were JPMorgan Chase and Bank of America.

Pushing up the minimum size for enhanced supervision is seen by some as increasing the riskiness of the U.S. banking system because banks newly exempt from enhanced supervision might take greater risks and become more likely to fail, thereby triggering a financial crisis comparable to the last one.

That would be a highly unlikely consequence of boosting the size threshold, for two key reasons.  First, banks newly exempt from enhanced supervision would still be subject to extensive safety-and-soundness supervision from banking regulators.

Second, large banks are subject to stockholder discipline. Poor performance by a large bank, such as reporting large loan losses, will trigger a decline in its stock price, creating market pressure to reduce the bank’s riskiness and strengthen its capital.

An important, yet little understood reason for raising the size limit is the perverse effect of the present limit, a perversity that has stimulated mergers among relatively large banks, thereby unintentionally increasing banking concentration in the U.S. economy.

Crossing the $50 billion threshold effectively imposes a substantial tax on a bank, in the form of additional regulatory compliance costs. That is why some banks slow their growth as they approach the $50 billion mark. At the end of 2016, there were two banks with $49 billion of assets; the next largest bank had $63 billion of assets. That size gap was not an accident.

Some banks, facing the $50 billion hurdle, have engineered a big merger so as to have a larger asset base over which to spread the suddenly higher cost of complying with the enhanced supervision to which they have become subject.

Changes in the size distribution of the country’s largest banks illustrate the cumulative effect of how bankers have gamed the $50 billion hurdle.

From year-end 2012 to year-end 2016, the number of banks with more than $1 trillion of assets held constant at four.  However, the number of banks with assets between $250 billion and $1 trillion increased from seven to eight. 

More dramatically, the number of banks with assets between $100 billion and $250 billion increased from 12 to 22.  On the other hand, the number of banks with assets between $50 billion and $100 billion declined from 12 to seven.

Banks in the next lower size range face an interesting challenge if the $50 billion size break does not change — do they merge with another bank to leap over the $50 billion mark or do they sell themselves to another bank? At the end of 2016, six banks — including one U.S. subsidiary of a Japanese bank — with assets between $39 billion and $50 billion face this dilemma.

Unfortunately, Congress is unlikely to pass stand-alone legislation that would boost the $50 billion trigger for enhanced supervision. Instead, such an increase would have to be included in broader financial regulatory reform legislation. The odds, though, of such legislation being enacted this year or next are not that high. Additionally, there are substantial differences between Republicans and Democrats over whether to raise the $50 billion figure and if so by how much. 

However, until that dollar amount is raised or the cost burden of enhanced supervision is reduced substantially, the perverse effect of the $50 billion minimum will continue to drive large-bank mergers, increasing concentration within the U.S. banking industry. That would not be a healthy trend.

Bert Ely is the principal of Ely & Company, Inc., where he monitors conditions in the banking and thrift industries, monetary policy, the payments system and the growing federalization of credit risk.

The views expressed by contributors are their own and not the views of The Hill.