Community Banks and Credit Unions: Impact of the Dodd-Frank Act Depends Largely on Future Rule Makings
Published: 2012-09-13T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Dodd-Frank Act includes numerous reforms to strengthen oversight of financial services firms and consolidate certain consumer protection responsibilities within CFPB. To help minimize its regulatory burden on small institutions, including community banks and credit unions, the act exempts such institutions from several of its provisions. However, the act also contains provisions that impose additional requirements on small institutions. Although no commonly accepted definition of a community bank exists, the term often is associated with smaller banks. Historically, community banks and credit unions have played an important role in providing credit to small businesses and other local customers.
This report examines (1) the significant changes community banks and credit unions have undergone in the past decade and the factors that have contributed to such changes, and (2) Dodd-Frank Act provisions that regulators, industry associations, and others expect to impact community banks and credit unions, including their small business lending. GAO analyzed regulatory and other data on community banks and credit unions; reviewed academic and other relevant studies; and interviewed federal regulators, community banks, credit unions, state regulatory and industry associations, academics, and others. CFPB, federal banking regulators, and the Securities and Exchange Commission provided technical comments on this report, which GAO incorporated as appropriate. CFPB and the National Credit Union Administration generally agreed with the report.
section_title: What GAO Found
paragraphs: While the number of community banks and credit unions has declined in recent years, they have remained important lenders to small businesses and other local customers. From 1985 through 2010, the number of banks under $10 billion in assets and credit unions declined by over 50 percent to 7,551 and 7,339, respectively. The decline resulted largely from consolidations, which were facilitated by changes in federal law that made it easier for banks and credit unions to expand geographically. Another factor that may have contributed to consolidations is economies of scale, which refer to how an institution's size is related to its costs. Although the existence of economies of scale in banking has been subject to debate, some recent research suggests that banks can save costs by expanding. Despite the decline in their number, community banks and credit unions have maintained their relationship-banking model, relying on their relationships with customers and local knowledge to make loans. Such institutions can use their relationship-based information to make loans to small businesses and other borrowers that larger banks may not make because of their general reliance on more automated processes. About 20 percent of lending by community banks can be categorized as small business lending (based on a commonly used proxy), compared to about 5 percent by larger banks. Community banks and credit unions also play an important role in rural areas, using relationship-based lending to serve customers with limited credit histories.
Although the Dodd-Frank Wall Street Reform and Consumer Protection Act's (Dodd-Frank Act) reforms are directed primarily at large, complex U.S. financial institutions, regulators, industry officials, and others collectively identified provisions within 7 of the act's 16 titles that they expect to have positive and negative impacts on community banks and credit unions. Industry officials told us that it is difficult to know for sure which provisions will impact community banks and credit unions, because the outcome largely depends on how agencies implement certain provisions through their rules, and many of the rules implementing the act have not been finalized. Thus, regulators and industry officials also have noted that the full impact of the Dodd-Frank Act on these institutions is uncertain. Nonetheless, some regulators and industry officials expect some of the act's provisions to benefit community banks and credit unions and other provisions to impose additional requirements on community banks and credit unions that could affect them disproportionately relative to larger banks. GAO analyzed a number of the Dodd-Frank Act provisions that regulators, industry officials, and others expect to impact community banks and credit unions. Several of the act's provisions, including its deposit insurance reforms, exemption from Section 404(b) of the Sarbanes-Oxley Act, and the Bureau of Consumer Financial Protection's (CFPB) supervision of certain nonbanks, could reduce costs and/or help level the playing field for community banks and credit unions. Other provisions, such as the act's mortgage reforms, may impose additional requirements and, thus, costs on generally all banks and credit unions, but their impact will depend on, among other things, how the provisions are implemented. Finally, industry officials generally told us that it is too soon to determine the Dodd-Frank Act's overall impact on small business lending and identified only one provision that contains a data collection and reporting requirement as potentially having a direct impact on such lending.

section_title: Letter
paragraphs: In 2008, the U.S. financial system and broader economy faced the most  severe financial crisis since the Great Depression. The crisis threatened  the stability of the financial system and contributed to the failure of  numerous financial institutions, including some large, complex financial  institutions. For example, 414 banks and 90 credit unions failed between  2008 and 2011, with such failures peaking in 2010. In response to the  crisis, Congress passed the Dodd-Frank Wall Street Reform and  Consumer Protection Act (Dodd-Frank Act), which became law on July  21, 2010. The act includes numerous reforms to strengthen oversight of  financial services firms and consolidate certain consumer protection  responsibilities within the Bureau of Consumer Financial Protection,  commonly known as the Consumer Financial Protection Bureau (CFPB).  Although the Dodd-Frank Act exempts small institutions, such as  community banks and credit unions, from several of its provisions, and  authorizes federal regulators to provide small institutions with relief from  certain regulations, it also contains provisions that will impose additional  restrictions and compliance costs on these institutions. Historically,  community banks and credit unions have played an important role in  serving their local customers, including providing credit to small  businesses.  the significant changes community banks and credit unions have  undergone in the past decade, and the factors that have contributed  to such changes; and
Dodd-Frank Act provisions that regulators, industry associations, and  others expect to impact community banks and credit unions, including  their small business lending.
To examine changes in community banks and credit unions, we analyzed  data from SNL Financial, a private financial database that contains  publicly filed and financial reports, including Consolidated Reports on  Condition and Income (Call Reports) submitted to the Federal Deposit  Insurance Corporation (FDIC), Thrift Financial Reports submitted to the  Office of Thrift Supervision (OTS), and 5300 Call Reports (Call Reports)  submitted to the National Credit Union Administration (NCUA). We used  SNL Financial data to identify changes in the total number, profitability,  lending activities, expenses, and other metrics of community banks and   We reviewed the SNL Financial  credit unions from 2002 through 2011.data and found the data to be sufficiently reliable for our purposes. We  also reviewed and analyzed relevant academic, regulatory, and industry  studies. We interviewed officials from FDIC, the Board of Governors of  the Federal Reserve System (Federal Reserve), the Office of the  Comptroller of the Currency (OCC), and NCUA, and the Small Business  Administration (SBA); officials from two state regulatory associations  (Conference of State Bank Supervisors and National Association of State  Credit Union Supervisors); representatives of industry associations,  including the American Bankers Association, Credit Union National  Association, Independent Community Bankers of America, and National  Association of Federal Credit Unions; and academics to obtain their  perspectives on industry changes.
To assess the Dodd-Frank Act’s impact on community banks and credit  unions, we reviewed the act and related materials, including relevant  congressional hearings; comment letters on proposed rules; and studies  and analyses prepared by federal and state regulators, industry  associations, law firms, and academics. We used Call Report and other  data compiled by SNL Financial to assess the extent to which community  banks and credit unions may be subject to or otherwise impacted by  various Dodd-Frank Act provisions. We reviewed the SNL Financial data  and found the data to be sufficiently reliable for our purposes. To help  identify Dodd-Frank Act provisions applicable to community banks and  credit unions and assess their impact on those institutions, we  interviewed the federal agencies, state regulatory and industry  associations, and others identified above, and CFPB. We discussed  public comments that some regulators received about proposed rules, but  regulators generally do not disclose how they will respond to such  comments until after the rules are finalized. In addition, based on  demographic factors, we interviewed four state banking and credit union  associations, and we randomly selected and interviewed 12 community  banks and credit unions to obtain information on the Dodd-Frank Act’s  provisions. Our interviews with this small sample of institutions provided  further insights on the expected impact of the Dodd-Frank Act, but the  responses are not generalizable to the population of community banks  and credit unions. Although we analyzed the impact of a number of  specific Dodd-Frank Act provisions on community banks and credit  unions, assessing the extent to which these provisions or their related  regulations should apply to such institutions was beyond the scope of our  work. Appendix I contains additional information on our scope and  methodology.
We conducted this performance audit between February and September  2012, in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: In the banking industry, the specific regulatory configuration for a banking  institution depends on the type of charter the institution chooses.  Depository institution charter types include:  commercial banks, which originally focused on the banking needs of  businesses but over time have broadened their services; thrifts, which include savings banks, savings associations, and  savings and loans, and were originally created to serve the needs— particularly the mortgage needs—of those not typically served by  commercial banks; and credit unions, which are member-owned cooperatives run by member- elected boards with an historical emphasis on serving people of  modest means.
These charters may be obtained at the state or federal level. State  regulators charter institutions and participate in their oversight, but all  institutions that offer federal deposit insurance have a prudential  regulator. The prudential regulators—which generally may issue  regulations for and take enforcement actions against industry participants  within their jurisdiction—are identified in table 1.
As shown in table 2, almost 7,400 (about 99 percent) of all banks had  less than $10 billion in assets in 2011 and thus fell within our definition of  a community bank. The majority of community banks have $250 million or  less in total assets. Although community banks comprise the vast majority  of all banks, they held in aggregate about 20 percent of the industry’s  total assets (about $2.8 trillion) in 2011.
Similarly, table 3 shows that the vast majority of credit unions (over 99  percent) had $10 billion or less in total assets in 2011. Furthermore,  around 80 percent of the credit unions had $100 million or less in total  assets.
The Dodd-Frank Act made important and fundamental changes to the  structure of the U.S. financial system to strengthen safeguards for  consumers and investors and to provide regulators with better tools for  limiting risk in the major financial institutions and the financial markets.  According to the Financial Stability Oversight Council, the core elements  of the act are designed to build a stronger, more resilient financial  system—less vulnerable to crisis, more efficient in allocating financial  resources, and less vulnerable to fraud and abuse. Under the Dodd- Frank Act, federal financial regulatory agencies are directed or have the  authority to issue hundreds of regulations to implement the act’s reforms.  The Dodd-Frank Act directs agencies to adopt regulations to implement  the act’s provisions and, in some cases, gives the agencies little or no  discretion in deciding how to implement the provisions. However, other  rule-making provisions in the act are discretionary in nature, stating that  (1) certain agencies may issue rules to implement particular provisions or  that the agencies may issue regulations that they decide are “necessary  and appropriate,” or (2) agencies must issue regulations to implement  particular provisions but have some level of discretion as to the substance  of the regulations. As a result, the agencies may decide to promulgate  rules for all, some, or none of the provisions, and often have broad  discretion to decide what these rules will contain. Many of the provisions  in the Dodd-Frank Act target the largest and most complex financial  institutions, and regulators have noted that much of the act is not meant  to apply to community banks. As such, the act directs regulators in a  number of areas to consider whether to exempt small banks and credit  unions. However, the act is comprehensive and far-reaching and will  impact smaller institutions, specifically those that undertake activities  thought to be precipitating factors in the 2007 through 2009 financial  crisis.
section_title: Community Banks and Credit Unions Have Declined in Number but Remain Important for Small Businesses and Agriculture
paragraphs: The number of community banks and credit unions has declined in recent  decades, as smaller institutions have expanded, merged with, or been  purchased by larger institutions. The trend of consolidation in banks and  credit unions has been facilitated by statutory and regulatory changes and  may have resulted, in part, from advantages in efficiency at larger  institutions. However, community banks and credit unions still play an  important role in the economy. Community banks and credit unions  allocate more of their lending to small businesses and rural areas than  large banks, which research suggests is due to their focus on  relationship-based lending.
subsections: section_title: Changes in Regulation and Other Factors Have Led to the Consolidation of Many Community Banks and Credit Unions
paragraphs: The number of community banks and credit unions has continued to  decline significantly since at least the mid-1980s. According to FDIC  research presented in 2012, the number of banks with less than $10  billion in assets declined from 17,997 to 7,551, or by about 58 percent,  between 1985 and 2010. Similarly, according to NCUA annual reports,  the number of federally insured credit unions declined from 15,045 to  7,339, or by about 51 percent, between 1985 and 2010. Despite the  decline in the number of credit unions, our analysis of Census data found  that membership in credit unions doubled over the same period. Our  analysis of SNL Financial data shows that the number of community  banks and credit unions declined further in 2011, to 7,385 and 7,094,  respectively.
The decline in the number of community banks and credit unions has  resulted largely from consolidations, in which two or more institutions  generally merge into one larger institution. In their 2012 research, FDIC  staff found that of the banks that exited the market between 1985 and  2010, 16 percent failed but 80 percent merged with another financial  institution or consolidated within a single holding company. FDIC staff  also found that the smallest banks (those with less than $100 million in  assets) experienced the largest decline in number, decreasing by 81  percent. Consistent with a pattern of consolidation and expansion, the  number of midsize banks (those with $250 million to $1 billion in assets)  and large banks (those with over $10 billion in assets) increased by 47  percent and 197 percent, respectively.
Two key statutory and regulatory changes have facilitated consolidation  by removing regulatory barriers to geographic and membership  expansion by banks and credit unions, respectively. First, the Riegle-Neal  Interstate Banking and Branching Efficiency Act of 1994 authorized  interstate mergers between banks starting in June 1997, regardless of  whether the transaction would be prohibited by state law. Previously,  most banks that wanted to operate across state lines had to establish a  bank holding company and, with certain restrictions, acquire or charter a  bank in each state in which they wanted to operate. With the advent of  interstate branching, banks that previously were not permitted to expand  across state lines could do so by acquiring existing banks, and some  multistate bank holding companies could consolidate their operations into   Second, after the passage of the  a single bank with multistate branches.Credit Union Membership Access Act in 1998, NCUA revised its  regulations to make it easier for federal credit unions to qualify for  community charters that allowed people to qualify for membership in a  credit union based on their geographic location (e.g., such as a county)  rather than based on their employer or affiliation in an organization. As a  result, community-chartered credit unions were able to expand, according  to one expert we interviewed, by consolidating with other local credit  unions, whose members resided in their geographic area. As we  previously reported, the total number of federally chartered credit unions  declined from 2000 through 2005, but the number of federal community- chartered credit unions more than doubled.
Another factor that may have contributed to consolidation is economies of  scale, which refer to how a bank’s or credit union’s scale of operations, or  size, is related to its costs. Increasing returns to scale are created when  an increase in size leads to a less than proportionate increase in cost  and, therefore, a decline in average cost. Banks and credit unions that  can take advantage of economies of scale can generate revenues at  lower costs by increasing their size through expansion and consolidation.  For example, a bank could reduce the average cost in its technology  investment by increasing the volume of its goods and services, and  thereby increase its profitability. Importantly, the existence of economies  of scale in banking has been subject to debate. Studies using data from  the 1980s failed to find scale economies beyond very small banks, but   For  later studies have found scale economies in various sized banks. example, a 2009 study covering all commercial banks from 1984 to 2006  found that banks had increasing returns to scale throughout the  distribution of banks, and the authors concluded that industry  consolidation had been driven, at least in part, by scale economies.Similarly, in a 2008 study of credit union consolidation presented at  FDIC’s Mergers and Acquisitions of Financial Institutions Conference,  researchers found that smaller and less profitable credit unions were  more likely to merge with other credit unions, and that the assets of a  small credit union might be used more efficiently if the credit union were  acquired and its assets were absorbed into a larger institution.
NCUA officials noted that while banks and credit unions often collect the same data,  comparisons between the two are limited because of differences in organizational  structure and regulation. Specifically, credit unions operate as not-for-profit institutions and  have limited fields of membership. similar to that of returns on assets, with large bank earning higher returns  on equity than small financial institutions from 2002 through 2006.  Moreover, the gap in returns on equity between large and small financial  institutions was greater than the gap in returns on assets before the  financial crisis. In their 2004 study, FDIC staff also found that smaller  institutions tend to have higher capital ratios than large banks, which also  leads to lower returns on equity at a given level of earnings.
Our analysis also indicates that community banks and credit unions have  generated revenues at higher average costs than large banks since  2002. As of the end of 2011, large banks earned $1.71 per dollar of  operating costs, while community banks earned $1.27 and credit unions  earned $1.09. We also found that larger community banks and credit  unions were more efficient than smaller institutions by this measure,  suggesting that those institutions may have benefited from some  economies of scale. As shown in figure 2, the difference in efficiency  between community banks and credit unions and large banks generally  remained consistent between 2002 and 2010. However, recent declines  in revenue per dollar of overhead cost at large banks, along with gains in  efficiency at community banks, decreased the difference in 2011.  Although community banks with less than $100 million in assets were the  least efficient in each year between 2002 and 2011, they (unlike the other  banks) experienced an overall increase in their efficiency over the period.  These measures of efficiency and profitability also can be influenced by  other factors outside of economies of scale, such as increased  competition. In April 2011, an OCC official testified that declines in net  interest margins have played a major role in decreasing community bank  profits.
Some research suggests that one area in which large banks are able to  take advantage of economies of scale is regulatory compliance, which  contributes to their advantage in terms of operational efficiency. Federal  regulators and state regulatory association and industry officials that we  interviewed stated that regulatory compliance costs are not regularly  tracked in Call Reports, and these costs have not been studied recently in  the research literature. Thus, information on economies of scale in this  area is limited. However, in a 1998 study, Federal Reserve staff reviewed  statistical studies that empirically examined possible economies of scale  in regulatory compliance at banks, noting that “if regulatory costs exhibit  economies of scale, smaller banks would face higher average costs in  complying with regulations than larger banks.” The studies found  statistical evidence that indicated economies of scale in compliance costs  for several regulations, which suggested that smaller banks, relative to  larger banks, have a cost disadvantage that may discourage the entry of  new firms into banking, may stimulate consolidation of the industry into  larger banks, and may inhibit competition among institutions in markets  for specific financial products. Additionally, several experts that we spoke  with said that smaller institutions are disproportionately affected by  increased regulation, because they are less able to absorb additional  costs.
section_title: Compared with Larger Banks, Community Banks and Credit Unions Allocate More of Their Lending to Small Businesses and Agriculture
paragraphs: Our analysis suggests that community banks have done more small  business and agricultural lending as a percentage of their total lending  than large banks over the past decade. To examine small business  lending, we used business loans of $1 million or less as a proxy for small  business loans at banks, though these loans were not necessarily made  to small businesses. As shown in figure 3, our analysis of SNL Financial  data found that about 18 percent of total lending at community banks was  small business loans, compared to about 5 percent at larger banks in  2011. Figure 3 also shows that while the difference between small  business lending at community banks and large banks has remained  fairly consistent over the past decade, small business lending as a  percentage of total lending declined at both community banks and large  banks by about 2 percent from 2002 through 2011. Despite allocating less  of their lending to small business loans, banks with more than $10 billion  in assets still made about 45 percent of all small business loans in 2011,  while accounting for about 1 percent of the total number of banks.
Community banks also have done significantly more agricultural lending  as a percentage of total lending than large banks, with the smallest  community banks allocating the highest percentage of lending to  agricultural loans. Our analysis found that banks with less than $100  million in assets had allocated about 14 percent of their lending to  agricultural loans on average from 2002 through 2011, while banks with  over $10 billion in assets had allocated less than 1 percent of their loans  to agriculture on average. In a 2003 study, Federal Reserve staff also  found that community banks played an important role in rural areas  generally, where they represented a much higher percent of branches  and deposits than in urban areas.banks represented nearly 58 percent of bank branches and 49 percent of   The study found that community  total deposits in rural areas, compared to 24 percent of branches and  around 14 percent of deposits in urban areas.
Some credit unions also make small business and agricultural loans, but  differences in regulation and structure make comparisons to banks  difficult. We found that small business lending at credit unions with less  than $10 billion in assets increased from about 2 percent to about 7  percent of their total lending from 2002 through 2011. A recent study  conducted on behalf of SBA found that credit union lending may have  offset some of the decrease in small business lending at banks. We  recently reported that such loans can be risky for credit unions and have  contributed to the failure of a number of credit unions. Specifically, we  reported that our analysis of NCUA and its Office of Inspector General’s  data indicated that member business loans contributed to 13 of the 85  credit union failures from January 2008 to June 2011. The Credit Union  Membership and Access Act of 1998 contains a provision that limits  business lending by credit unions to the lesser of 12.25 percent of total   Experts and credit union officials told  assets or 175 percent of net worth.us that smaller credit unions may not be able to engage profitably in small  business lending due in part to the lending cap. To engage in such  lending, these officials told us a credit union has to develop business  lending expertise and resources and may need to hire additional staff, but  the cap may not allow them to make the volume of loans needed to cover  these costs. Larger credit unions are able to make more loans under the  cap and thus are better able to develop the necessary resources. Our  analysis found that small business lending increased much more  dramatically at credit unions with at least $100 million in assets from 2002  through 2011. Figure 4 shows that small business lending at these large  credit unions increased from about 2 percent of total loans in 2002 to  nearly 8 percent in 2011. While most credit unions do little or no  agricultural lending, some credit unions have been chartered specifically  to provide agricultural credit, and industry officials told us that these  institutions play key roles in their communities.
Research has indicated that community banks and credit unions have  advantages over larger banks in providing small business loans and loans  in rural areas because of their direct relationships with and knowledge of  individual customers. The 2003 study by Federal Reserve staff found that  community banks have focused on “relationship banking,” basing lending  decisions on personal knowledge of their customers and an  understanding of their local economies. The study contrasted this  approach to that of large banks, which often rely on data, credit scoring,  and centralized decision making. FDIC staff noted that relationship  lending gives community banks the ability to lend to borrowers without  long credit histories, because it allows them to use nonstandard  information to make profitable loans to customers who are seen as high  risk by large banks. Experts we spoke with noted that small businesses  often do not have audited financial statements and other data that may be  used by large banks in credit scoring models. One expert stated that  loans to small business and rural residents tend to have nonstandard  terms and require knowledge of the personal or professional history of the  business or person seeking the loan. As shown in figure 5, we found that  loans make up a slightly greater proportion of their total assets, which  suggests that community banks and credit unions may be more focused  on traditional lending services than large banks.
section_title: Many Dodd-Frank Act Provisions May Affect Community Banks and Credit Unions, but the Full Extent of Their Impact Is Uncertain
paragraphs: The Dodd-Frank Act’s reforms are directed primarily at large, complex  U.S. financial institutions, and the act exempts small institutions, including  community banks and credit unions, from several of its provisions.  However, federal regulators, state regulatory associations, and industry  associations collectively identified provisions within 7 of the act’s 16 titles  that they expect to impact community banks and credit unions. (See app.  II for the Dodd-Frank Act provisions identified by the above entities.) We  analyzed the impact of a number of these Dodd-Frank Act provisions and,  in brief, found that:  some provisions, including the depository insurance reforms and  CFPB supervision of nonbank providers of financial services and  products, have benefited or may benefit community banks and credit  unions; certain of the act’s mortgage reforms are expected to impose  additional costs on community banks and credit unions, but their  impact depends on future rule makings; the act’s risk retention provision for securitizations is expected to  initially have a limited impact on community banks and credit unions;  and other provisions, including those covering proprietary trading,  remittance transfers, and executive compensation, are expected to  impose additional requirements on community banks and credit  unions, but their impact depends partly on future rule makings.
Industry officials told us that determining which provisions will affect small  institutions is difficult, because the impact may depend on how agencies  implement certain provisions through their rules, and many of the rules  needed to implement the act have not been finalized.reason, regulators and industry officials have noted that the full impact of  the Dodd-Frank Act on community banks and credit unions is uncertain.  Nonetheless, regulators and industry officials have noted that they expect  that some of the act’s regulations will increase regulatory requirements on  community banks and credit unions and disproportionately affect them   For the same  relative to larger banks because of their size. Moreover, some industry  officials have expressed concern that the reforms targeting only large  banks eventually will be applied to small institutions in varying degrees,  for example, through industry best practices. In our interviews with  officials from community banks and credit unions, several told us that they  may reduce certain business activity or exit certain lines of business as a  result of the new regulations. However, some also have cited benefits of  particular provisions for smaller institutions.
As recognized by federal regulators, industry officials, and others, the  Dodd-Frank Act contains several provisions to help minimize certain  regulatory requirements on small institutions. For example, the act  includes provisions that generally exempt (1) small bank holding  companies from certain leverage and risk-based capital requirements, (2)  small banks and credit unions from supervision by CFPB, (3) small debit  card issuers from the debit interchange fee standards, and (4) small  financial institutions from disclosure and reporting requirements for  incentive-based compensation arrangements. The Dodd-Frank Act also  provides federal agencies with the authority to provide small institutions  with relief from certain regulations. For example, the act and certain of the  federal consumer financial laws provide CFPB with the authority to  exempt covered persons or transactions from certain CFPB rules, and it  directs the Commodity Futures Trading Commission (CFTC) and the  Securities and Exchange Commission (SEC) to consider exempting small  banks and credit unions from their swap clearing requirements.
CFPB, FDIC, the Federal Reserve, OCC, and NCUA have undertaken  various efforts to reach out to community banks and credit unions outside  of the examination process, in part to understand challenges being raised  for them by the Dodd-Frank Act. Examples of such outreach efforts  include the following:
CFPB has created the Office of Small Business, Community Banks,  and Credit Unions, to help it incorporate the perspectives of these  institutions in its policy-making process, communicate relevant policy  initiatives to them, and work with them to identify areas for regulatory  streamlining. According to CFPB officials, CFPB has convened three  small business panels in conjunction with SBA’s Chief Counsel for  Advocacy and the Office of Management and Budget’s Office of  Information and Regulatory Affairs.
FDIC has held roundtable discussions with community banks in each  of its regions and a community bank conference. It is researching a  variety of issues involving community banks and expects to issue its  study by the end of 2012. In 2009, FDIC established the FDIC  Advisory Committee on Community Banking to provide it with advice  and guidance on policy issues affecting community banks, and the  committee’s meetings have included discussions of the Dodd-Frank  Act.
In October 2010, the Federal Reserve formed the Community  Depository Institutions Advisory Council to provide the agency with  direct insight and information from community bankers about  supervisory matters and other issues of interest to community banks.  In a recent testimony, a Federal Reserve official noted that the agency  expects these ongoing discussions to provide a useful and relevant  forum for improving its understanding of the effect of legislation,  regulation, and examination activities on small banking  organizations.
OCC has conducted a variety of outreach activities, including Meet  the Comptroller events, chief executive officer roundtables, and  teleconferences on topical issues. In preparation for the transfer of  federal savings associations to OCC supervision, OCC presented  numerous programs for thrift executives around the country to provide  information and perspective on OCC’s approach to supervision and  regulation. OCC also has chartered advisory committees for federal   savings associations with mutual charters and minority-owned  institutions similar to those OTS had chartered.
NCUA officials told us that to assist credit unions in complying with the  Dodd-Frank Act, they have posted articles on their website, conducted  a webinar with the CFPB director, and issued letters to credit unions  on any rule changes.
As presented below, we analyzed a number of the Dodd-Frank Act  provisions that regulators, industry officials, and others expect to impact  community banks and credit unions. While several of these provisions  have been implemented through finalized rules, most have not. The  impact of those provisions will depend, in part, on how they are  implemented by federal agencies through their regulations. As the act’s  impact on individual banks and credit unions will depend on their  organizational form, mix of activities, or other factors, our analysis  focused on assessing, where data were available, which of these  institutions may be subject to the selected provisions. As part of our  analysis, we also document industry and other views on the potential  impact of the provisions and the status of regulations needed to  implement the provisions. As noted above, assessing whether such  provisions or their related regulations should apply to community banks  and credit unions was beyond the scope of our work.
subsections: section_title: Some Provisions Have Reduced Costs or Provided Other Benefits
paragraphs: Some of the Dodd-Frank Act provisions that we analyzed have benefited  or may benefit community banks or credit unions, such as by reducing  costs.
The Dodd-Frank Act’s depository and share insurance reforms have  reduced costs for community banks and increased consumer confidence  to the benefit of community banks and credit unions. Title III of the Dodd- Frank Act includes several provisions reforming the Deposit Insurance  Fund (DIF) and National Credit Union Share Insurance Fund. For  example, section 331 revised the method used to calculate DIF  assessments. Section 335 permanently increased the standard deposit  and share insurance coverage amount from $100,000 to $250,000.  Section 343 provided temporary unlimited deposit and share insurance  coverage for non-interest-bearing transaction accounts, such as  consumer checking accounts.
Section 331 required FDIC to redefine the DIF assessment base,  generally basing it on average consolidated total assets rather than  domestic deposits, on which it was previously based. According to FDIC,  the change in the assessment base shifted some of the overall  assessment burden from community banks to the largest institutions,  which rely less on domestic deposits for their funding than smaller  institutions, but without affecting the overall amount of assessment  revenue collected. As shown in table 4, after the rule became effective on  April 1, 2011, DIF assessments for community banks (those with less  than $10 billion in assets) decreased in aggregate by $342 million, (33   According to FDIC,  percent) from the first to second quarter of 2011.this rule has resulted in a sharing of the DIF assessment burden that  better reflects each group’s share of industry assets. Officials from  industry associations told us that they viewed this change as positive for  community banks overall. In addition, officials from the two community  bank state associations told us that assessments likely have decreased  for their member institutions. Also, officials from five community banks  told us that their assessments have either decreased or stayed about the  same, but officials from three community banks told us that that their  assessments had increased (one of these banks has between $1 billion  to $10 billion in assets).
Section 335 made permanent the temporary increase of the maximum  deposit and share insurance amounts from $100,000 to $250,000.  Beginning in October 2008, the deposit and share insurance coverage  had been increased temporarily to $250,000 to help consumers maintain  confidence in the banking system and the marketplace. These  increases were made permanent and effective in August and September  2010, respectively. According to FDIC, the higher insurance coverage  level should help community banks attract and retain core deposits.  Industry associations and officials from the community banks and credit  unions we spoke with generally viewed the increase in insurance  coverage as beneficial to community banks and credit unions.
Section 343 provided temporary unlimited deposit and share insurance  coverage for non-interest-bearing transaction accounts from December  31, 2010, through December 31, 2012. According to FDIC, the 10.7  percent increase in insured deposits during 2011 was primarily  attributable to growth in non-interest-bearing transaction account  balances receiving temporary coverage. However, according to an  NCUA official, non-interest-bearing transaction accounts typically are held  by businesses for payroll and accounts payable and, therefore, are less  common at credit unions than at banks. Although this insurance program  was designed to be a temporary response to financial instability, several  industry associations representing banks are advocating for this provision  to be extended. In addition, officials from two state associations  representing community banks we spoke with said they expect the  termination of the coverage to have a negative or very negative impact on  their member institutions. In contrast, officials from the two state  associations representing credit unions said they expect the termination  would have no impact. But the responses from the individual community  banks and credit unions were more mixed. Officials from five of the eight  community banks and two of the four credit unions we spoke with said  that they expect the termination of the coverage to have a negative or  very negative impact on their institution. Officials from the other three  community banks and two credit unions said that the termination would  have no impact on their institution or it was too soon to determine the  impact.
Section 989G of the Dodd-Frank Act eliminates an audit requirement for a  number of small community banks and bank holding companies that are  public companies. In response to numerous corporate failures arising  from corporate mismanagement and fraud, Congress passed the  Sarbanes-Oxley Act of 2002 to help protect investors, in part by improving  the accuracy, reliability, and transparency of corporate financial reporting  and disclosures. Specifically, section 404(a) of the Sarbanes-Oxley Act  requires a public company’s management to assess and report on the  effectiveness of its internal controls over financial reporting. In turn,  section 404(b) requires an independent auditor to attest to and report on  management’s assessment. Under SEC rules, non-accelerated filers  (generally defined as public companies with a public float under $75  million) have been required to comply with section 404(a) for fiscal years   However, before the passage of  ending on or after December 15, 2007.the Dodd-Frank Act, these filers were not required to comply with section  404(b) for fiscal years ending before June 15, 2010. SEC had provided  such issuers with several extensions to the compliance dates in response  to concerns about compliance costs and management’s preparedness.
Section 989G of the Dodd-Frank Act amended the Sarbanes-Oxley Act to  exempt non-accelerated filers from section 404(b). Using SNL Financial  data, we found that around 630 publicly traded financial institutions,  including community banks and bank holding companies, identified  themselves as non-accelerated filers. These financial institutions may  qualify for the exemption and not have to incur the audit-related costs to  comply with section 404(b). In a 2009 survey, which included 99 public  companies with a public float under $75 million, SEC’s Office of Economic  Analysis found that these companies had incurred a median (average)  annual cost of $157,500 ($259,004) to comply with section 404(b)  following reforms SEC made in 2007. In our prior work, we found that  smaller public companies faced disproportionately higher costs (as a  percentage of revenues) in complying with section 404.
Unlike large banks, community banks and credit unions generally have  not, on average, experienced a significant decline in their debit  interchange fees as a result of the Federal Reserve’s implementation of  section 1075 of the Dodd-Frank Act. Debit cards can be used to make  noncash purchases at merchants. When a consumer uses a debit card to  make a purchase, the merchant does not receive the full purchase  amount. Part of the amount (called the merchant discount fee) is  deducted and distributed among the merchant’s bank, debit card issuer,  and payment card network processing the transaction. Historically, the  majority of the merchant discount fee was paid from the merchant’s bank  to the debit card issuer in the form of an interchange fee. Debit card  interchange fees are established by card networks and ultimately paid by  merchants to debit card issuers for each electronic debit transaction.
In July 2011, the Federal Reserve adopted Regulation II (Debit Card  Interchange Fees and Routing) to implement section 1075 of the Dodd- Frank Act. Regulation II establishes standards for assessing whether  debit card interchange fees received by issuers are reasonable and  proportional to the costs incurred by issuers for electronic debit  transactions. The rule sets a cap on the maximum permissible  interchange fee that an issuer may receive for an electronic debit  transaction at $0.21 per transaction, plus 5 basis points multiplied by the  transaction’s value. The fee cap became effective on October 1, 2011.  However, the rule exempts from the fee cap issuers that have, together  with their affiliates, less than $10 billion in assets, and transactions made  using debit cards issued pursuant to government-administered payment  programs or certain reloadable prepaid cards. In addition, Regulation II  prohibits issuers and card networks from restricting the number of  networks over which electronic debit transactions may be processed to  less than two unaffiliated networks. The rule further prohibits issuers  and networks from inhibiting a merchant from directing the routing of an  electronic debit transaction over any network allowed by the issuer.
Institutions that qualified for the exemption during 2011 were those institutions that had,  together with affiliates, assets of less than $10 billion as of December 31, 2010. the first three quarters of 2011 to $0.43 in the fourth quarter of 2011.  During the same period, the interchange fee as a percentage of the  average transaction value for exempt issuers declined from 1.16 percent  to 1.10 percent. In comparison, the average interchange fee received by  issuers subject to the fee cap (nonexempt issuers) declined from $0.50 to  $0.24, or by 52 percent, between the two periods. Our analysis of SNL  Financial data shows that interchange fee income received by around  6,450 exempt banks increased, in aggregate, on a quarterly basis after  the rule became effective, but the data do not allow us to determine why  fee income increased, such as because of an increase in transaction  volume. The aggregate interchange fee income reported quarterly by  these banks from the second quarter of 2011 through the first quarter of  2012 was about $532 million, $547 million, $575 million, and $585 million,  respectively.
Although Regulation II has had a limited impact on exempt issuers to  date, concerns remain about the potential for their interchange fees or fee  income to decline over the long term. For example, industry officials and  others have noted that (1) some merchants may steer customers to  lower-cost payment options, even if networks maintain a two-tiered fee  structure, (2) the prohibition on network exclusivity and routing restrictions  may lead networks to lower their interchange fees, in part to encourage  merchants to route debit card transactions through their networks, or (3)  economic forces may cause networks not to maintain a two-tiered fee  structure that provides a meaningful differential between fees for exempt  and other issuers. Some merchants and others have noted that major  card networks have adopted a two-tiered fee structure and have an  incentive to maintain that structure to attract exempt issuers. According  to Federal Reserve officials, the agency plans to collect data annually that  analyze the rule’s impact on exempt issuer fees. It also plans to survey  exempt issuers in 2012 to determine how much it cost them to comply  with the network exclusivity prohibition and whether any merchants are  refusing to accept their debit cards.
section_title: CFPB Provisions May Help Level the Regulatory Playing Field but also May Result in Additional Compliance Requirements
paragraphs: According to some regulators and industry officials, subjecting certain  nonbank providers of financial services or products (nonbanks) to federal  consumer protection laws and CFPB supervision may benefit community  banks and credit unions by helping to level the regulatory playing field.  Although community banks and small credit unions are not supervised by  CFPB, they generally are subject to its regulations. CFPB’s  implementation of the Dodd-Frank Act’s mortgage-related and other  provisions are expected to impose additional requirements on community  banks and credit unions. However, the impact of these regulations will  depend on how CFPB implements such provisions and exercises its  exemption authority. The Dodd-Frank Act established CFPB and  authorized it to supervise certain nonbank financial companies and large  banks and credit unions with over $10 billion in assets and their affiliates  for consumer protection purposes. Before the Dodd-Frank Act,  responsibility for administering and enforcing consumer financial laws for  these entities was spread across several federal agencies. The act  transferred supervisory and enforcement authority over a number of  consumer financial institutions and services, as well as rule-making and  enforcement authority (for those institutions it supervises) over many  previously enacted consumer protection laws, to CFPB.
Section 1024 of the Dodd-Frank Act authorizes CFPB to supervise certain entities and  individuals that engage in offering or providing a consumer financial product or service  and their service providers that are not covered by sections 1025 or 1026 of the act.  Specifically, section 1024 applies to those entities and individuals who offer or provide  mortgage-related products or services and payday and private student loans as well as  larger participants of other consumer financial service or product markets as defined by a  CFPB rule, among others, plus their service providers. Section 1025 authorizes CFPB to  supervise, with respect to consumer finance laws, large insured depository institutions and  credit unions with more than $10 billion in total assets and all their affiliates (including  subsidiaries), as well as service providers for such entities. Under section 1026, CFPB  has the authority to require reports, as necessary, from banks and credit unions under $10  billion, and CFPB, at its discretion, may include its examiners on a sampling basis in  examinations conducted by their prudential regulator for these entities. Under sections  1026 and 1061(c), CFPB has supervisory authority over a service provider to a substantial  number of smaller depository institutions. factors that focus on risk to consumers, nonbanks engaged in the  residential mortgage industry, private education lending, and payday  lending. For other financial services or product markets, CFPB’s authority  applies only to a “larger participant.” CFPB’s supervisory authority also  covers nonbanks that it has reasonable cause to determine are engaging,  or have engaged, in conduct that poses risks to consumers with regard to  the offering or provision of consumer financial products or services. In  January 2012, CFPB launched its nonbank supervision program, under  which it examines such entities for, among other things, compliance with  federal consumer financial laws. According to CFPB, nonbanks will be  identified for examination based on risks to consumers, including  consideration of the company’s asset size, volume of consumer financial  transactions, extent of state oversight, and other relevant factors.
Regulators and industry representatives expect CFPB supervision of  nonbanks to benefit community banks and credit unions by leveling the  regulatory playing field. For example, in 2011, an FDIC official testified  that CFPB will likely reduce the unfair competitive advantage that  nonbanks have long enjoyed as under-regulated—and often unregulated  and unsupervised—financial services providers. Industry officials have testified that community banks and credit unions did not engage in  abusive lending practices and were not the cause of the financial crisis,  and urged CFPB to focus its efforts on regulating nonbanks as many of  the problems that led to the financial crisis began outside the regulated  banking industry. Officials from half of the 16 state associations,  community banks, and credit unions we interviewed told us that they  expect CFPB supervision of nonbanks to have a positive impact. Officials  from three of these entities expect CFPB supervision to have no impact,  three thought it was too soon to tell, and two thought it could have a  negative impact.
The Dodd-Frank Act grants broad rule-making authority to CFPB, but  requires it to coordinate with other federal agencies to ensure consistency  in its regulation of consumer products and services. Although CFPB does  not directly supervise community banks and small credit unions, its  regulations generally apply to all banks and credit unions (and most  nonbanks). According to CFPB, its rule-making activities have focused on  two main areas: implementing protections required by the Dodd-Frank Act  and streamlining inherited regulations. Pursuant to the Dodd-Frank Act,  CFPB has proposed or finalized various regulations involving the  mortgage market and international money transfers (discussed below). In  December 2011, CFPB issued a notice requesting public comment on  how to streamline existing regulations implementing federal consumer  financial laws.
Section 1022 of the Dodd-Frank Act permits CFPB to exempt any class of  product or institution, including small institutions, from its regulations  issued under Title X of the act. In issuing any such exemption, CFPB  must take into account several factors, including the existing provisions of  law applicable to the consumer financial product or service and the extent  to which such provisions provide consumers with adequate protections.  Furthermore, other federal consumer financial laws provided CFPB with  varying degrees of exemption authority, generally with respect to classes  of transactions where certain conditions are met. In a recent testimony,  the CFPB Director said that when it is appropriate to treat smaller  institutions differently from larger institutions, CFPB will consider doing  so. Similarly, CFPB staff told us that they will need to determine how  much regulatory relief the agency will provide small institutions on a rule- by-rule basis. For example, in early July 2012, pursuant to sections  1032(f), 1100A, and 1098 of the Dodd-Frank Act, CFPB proposed a rule  to integrate mortgage disclosures required by two different mortgage- lending-related statutes into one form. In the proposed rule, CFPB is  considering exempting small entities (including some banks and credit  unions with $10 billion or less in assets) from electronic data retention  requirements to reduce their burden. In addition, CFPB is seeking  comment on how much time industry needs to make any changes  required in implementing the rule and whether small entities should have  more time.
While many consumer protection and mortgage reforms are not yet  finalized, CFPB staff told us that they are in the process of proposing  several additional regulations to provide guidance to the mortgage  industry in implementing new reforms under the Dodd-Frank Act. As  mandated by the statute, most of these rules are due in final form by  January 21, 2013. However, industry representatives and others have  expressed concern about the potential impact of CFPB regulations on  community banks and credit unions. In congressional testimony and our  interviews, industry representatives have said that they are hopeful that  CFPB will be able to consolidate and simplify rules for all financial  institutions. They also have noted that CFPB has conducted outreach  efforts to obtain input on CFPB’s activities. However, industry  representatives expressed concern that the numerous new regulations  from CFPB will impose additional regulatory burden and compliance costs  on small institutions, potentially causing them to exit certain lines of  business. Specifically, they cited concerns about the additional time,  resources, and effort it would take their institutions to address new  regulatory requirements. In particular, they were concerned about having  to comply with numerous regulations issued around the same time by  CFPB. Industry representatives also were concerned that the  standardization of processes through CFPB regulations could reduce the  ability of community banks and credit unions to offer differentiated  products to better serve their communities. In congressional testimony  and our interviews, community bank and credit union associations and  representatives have emphasized that they believe these entities have a  long history of serving customers fairly. Some commented that it is their  opinion that CFPB regulations should not apply to them as they did not  engage in the types of abuses that prompted the passage of the Dodd- Frank Act. Credit union representatives added that credit unions are  owned by their members and, thus, have a strong incentive to treat their  consumers well.
section_title: Mortgage Reforms Are Expected to Impose Additional Costs, but Their Impact Depends on Future Rule Makings
paragraphs: The Dodd-Frank Act’s mortgage reform provisions are expected to  impose additional costs on a large percentage of community banks and  credit unions. However, the full cost to these entities will depend on the  extent to which CFPB (and other agencies where appropriate) exercises  its authority, where available, to exempt small institutions from any of its  regulations and how it implements specific provisions that provide more  limited relief to small institutions, particularly those operating in rural or  underserved communities. The act’s mortgage reforms include (1)  additional origination and servicing requirements; (2) minimum standards  for mortgage loans (including determining a borrower’s ability to repay the  loan); (3) limits on charges for mortgage prepayments; (4) expanding the  definition of “high-cost mortgages” and protections that apply to such  loans; (5) new disclosure requirements; (6) establishing various appraisal  standards; and (7) requiring additional data elements to be reported  under the Home Mortgage Disclosure Act (HMDA) reporting  requirements. The Dodd-Frank Act’s mortgage reforms generally seek  to address substandard residential mortgage lending practices that  contributed to spikes in foreclosures and the 2007 through 2009 financial  crisis. A key challenge in implementing these reforms is balancing the  goals of protecting consumers from abuse and maintaining broad access  to credit. Authority for implementing these reforms generally was  transferred from the Federal Reserve to CFPB in July 2011.the rule-making authority for most of these regulations, and in other cases  agencies are jointly responsible for rule making. While federal agencies  have proposed a number of rules to implement the act’s mortgage  reforms, most of the required rules have not been finalized.
The Dodd-Frank Act’s mortgage reforms could apply to and impact the  vast majority of community banks and credit unions, given their  involvement in mortgage lending. On the basis of our analysis of SNL  Financial data, over 97 percent of community banks and over 70 percent  of credit unions held residential mortgage loans in 2011. Over the past 5  years, community banks within different asset-sized categories generally  dedicated about 30 percent of their lending portfolios to mortgage lending.  However, mortgage lending by credit unions was more varied by asset  size. As a percentage of a credit union’s total lending portfolio in 2011,  mortgage lending comprised, on average, over 50 percent for credit  unions holding more than $100 million in assets, about 44 percent for  those with $20 million to $100 million in assets, about 26 percent for  those with $5 million to $20 million in assets, and about 7 percent for  those with less than $5 million in assets.
Although the Dodd-Frank Act’s mortgage reforms may affect the majority  of community banks and credit unions, precisely how or to what extent  the reforms will affect these institutions is uncertain. Many of the reforms  have not yet been implemented; therefore, data do not exist to assess  their impact. However, some regulators and industry representatives  expect the potential cumulative effect of the mortgage reforms to increase  the regulatory burden for smaller institutions, potentially leading them to  decrease certain mortgage lending activities or, at the extreme, exit the  mortgage business. In our interviews with state associations, community  banks, and credit unions, officials from 9 of the 16 entities told us that  they expected the act’s mortgage reforms to decrease their or their  member institutions’ lending, but officials from seven of the entities told us  it was too soon to determine the reforms’ potential impact. Some officials  also told us that the mortgage reforms may reduce community banks’ and  credit unions’ advantage not only in serving niche markets (e.g., rural  communities) by standardizing mortgage terms but also in making loans  based on “soft information” by increasing the cost of providing these  loans. Evaluating these concerns is difficult, especially given the CFPB’s  regulatory flexibility. As discussed in the previous section, the Dodd-Frank  Act and federal consumer financial protection laws provide CFPB with  varying amounts of exemptive authority with regard to particular  transactions and circumstances. In addition, the Dodd-Frank Act’s  provisions that establish minimum standards for mortgage underwriting  (“ability-to-repay” provision), additional escrow requirements, and  appraisal standards provide some exceptions and regulatory relief for  small institutions. These particular provisions were identified by regulators  and industry representatives as potentially having a significant impact on  community banks and credit unions.
Sections 1411 and 1412 of Title XIV of the Dodd-Frank Act amended the  Truth in Lending Act (TILA) by prohibiting creditors from making mortgage  loans without regard to consumers’ ability to repay them and establishing  standards for making a reasonable and good faith determination based  on verified and documented information. This reform was enacted to  address the loosening of underwriting standards, which was partly  responsible for the dramatic increase in mortgage delinquencies and  foreclosures beginning in 2006. A creditor can meet the ability-to-repay  requirement by satisfying certain underwriting factors, or the creditor may  also be presumed to have satisfied the ability-to-repay requirement and  receive some protection from liability if it originates a “qualified mortgage”  (QM) as defined by criteria in the Dodd-Frank Act and implemented by  CFPB. In other sections of subtitle B of Title XIV, the act sets steeper  penalties for noncompliance with the requirements and allows consumers  to cite ability-to-repay violations as a set off in foreclosures.
In a 2011 report, we examined five of the nine QM criteria specified in the  Dodd-Frank Act for which sufficient data were available and generally  found that most mortgages likely would have met the individual criteria for  each year from 2001 through 2010. However, we noted that the impact  of the full set of QM criteria was uncertain, partly because data limitations  made analysis of the other four criteria difficult and partly because CFPB  could establish different criteria in developing final regulations. Consumer  and industry groups indicated that the criteria specified in the act would  likely encourage sound underwriting, but could also restrict the availability  of and raise the cost of mortgage credit for some homebuyers. Provisions  in the act and proposed regulations attempt to address some of these  issues, in part by providing exemptions for certain loan products in certain  locales, such as rural areas.
Within subtitle E of Title XIV, sections 1461 and 1462 of the Dodd-Frank  Act amended TILA to expand escrow requirements for certain types of  mortgage loans to enhance consumer protection. Before the Dodd- Frank Act, regulations issued under TILA required that creditors establish  escrow accounts for taxes and insurance for higher-priced residential  mortgage loans. The Dodd-Frank Act substantially codified these  requirements and lengthened the time during which a mandatory escrow  account established for a higher-priced mortgage loan must be  maintained from 1 to 5 years. In addition, the act established additional  disclosure requirements for escrow accounts.
Both the ability-to-repay and escrow provisions may provide some relief  to creditors operating in predominantly rural or underserved communities.  As discussed previously, smaller banks generally have higher levels of  agricultural loans as a percentage of their total lending portfolios. In  addition, some credit unions are chartered specifically to serve  agricultural communities. Community banks and credit unions may make  balloon loans to help ensure access to credit in rural or underserved  communities where consumers may be able to obtain credit only from  these institutions offering such loans and to hedge against interest rate  risk. Section 1412 of the Dodd-Frank Act defines a balloon payment as a  scheduled payment that is more than twice as large as the average of  earlier scheduled payments. Under this provision, CFPB may by  regulation allow some creditors, including those operating in  predominantly “rural or underserved” areas, to make balloon-payment  QMs that meet certain criteria. In other cases, balloon-payment loans  may not be considered QMs, and creditors making these loans would not  be protected from certain liabilities. The act provides a similar exemption  from mandatory escrow requirements for similar types of creditors. To  qualify for these exemptions, in both cases, creditors must operate in  predominately rural or underserved areas, be under total annual asset  and mortgage loan origination limits to be set by CFPB (initially set by the  Federal Reserve, see following discussion), and retain their mortgage  loans in their portfolios. The intent behind these exemptions is to preserve  access to credit for consumers located in rural or underserved areas,  where creditors may originate balloon loans to hedge against interest rate  risk or higher-priced mortgages, but in volumes too small to justify the  expense of establishing and maintaining escrow accounts for loans held  in portfolio.
Before the transfer of rule-making authority for TILA to CFPB, the Federal  Reserve proposed rules to implement both the ability-to-repay and  escrow requirements. In May 2011, the Federal Reserve proposed   Its  regulations for compliance with the ability-to-repay provisions.proposal provided a definition for a QM and, in accordance with the act,  proposed that creditors with under $2 billion in assets operating  predominantly in “rural or underserved” areas may make a balloon- payment QM that meets certain conditions. Due to the lack of available  data, the agency requested comment on how to set a mortgage loan  origination limit. In March 2011, the Federal Reserve proposed rules for  implementing the act’s escrow requirements. With respect to the  exemption, the agency proposed a threshold of no more than 100 total  mortgage loan originations a year and chose not to propose an asset-size  threshold. In both rules, the Federal Reserve defined “underserved” areas  as counties where not more than two creditors may make five or more  mortgages a year and “rural” areas as counties classified by the U.S.  Department of Agriculture as representing the most remote rural areas— where access to the resources of more urban communities and mobility is  limited.
In their comment letters on these proposed rules, community bank and  credit union associations supported the intent of the reforms but were  concerned about regulatory burden. One community bank association  noted that the additional requirements could lead to an economic  environment where only larger creditors would continue doing business,  as they generally are better equipped to absorb increased regulatory  costs. Industry representatives added that community banks and credit  unions had not engaged in the abusive lending practices or substandard  underwriting practices the mortgage provisions sought to address. For  example, a community bank association noted that community banks  have provided balloon loans in small communities for decades without  problems and that these types of loans may be the only available credit  option for consumers in rural communities. They also noted that many  balloon loans would fall under the definition of higher-priced loans and,  therefore, would be covered by the mandatory escrow requirement. In our  interviews with state associations, community banks, and credit unions,  officials from 8 of the 16 entities expected the ability-to-repay provisions  to decrease their or their member institutions’ mortgage lending, four  thought the provisions would have no impact, and four thought it was too  soon to tell.
For both of the proposed rules, a state regulatory association and several  industry associations emphasized the importance of the exemptions for  small institutions, but disagreed with how “underserved” and “rural” areas  were defined and, in turn, proposed that their definitions be expanded.  They said the proposed definitions were too narrow and complicated, and  would exclude many community banks and credit unions that should be  covered. A state regulatory association and industry associations also  supported expanding these exemptions to cover all creditors holding  loans in portfolio, maintaining that these institutions have an incentive to  ensure higher standards of underwriting and retain the risk associated  with consumers failing to pay taxes and insurance. With respect to the  escrow requirements, industry representatives suggested increasing the  proposed threshold of 100 loans.
As of August 2012, CFPB has not finalized either rule. In early June 2012,  CFPB reopened the comment period for the proposed ability-to-repay  rule. In particular, CFPB requested additional data on mortgage lending  underwriting criteria and loan performance, as well as estimates of  litigation costs and liability risks associated with claims alleging ability-to- repay requirement violations. CFPB expects to issue final rules for the  ability-to-repay provisions and the escrow requirements by the end of this  year. According to the Dodd-Frank Act, these provisions become effective  18 months after rule-making authority was transferred to CFPB (that is,  January 21, 2013) if implementing regulations have not been issued.  Where implementing regulations are issued by the deadline, the statutory  provisions take effect when the rules take effect. In some cases,  implementing rules must take effect within 12 months of issuance.
Subtitle F of Title XIV established additional appraisal requirements for  mortgage lending. Among other provisions, section 1471 establishes  additional requirements for “higher risk” mortgages. Section 1472 of the  act amends TILA to require that appraisers be independent to reduce any  conflicts of interests. It declared the Home Valuation Code of Conduct,  the previous standard for appraisal independence for loans purchased by  Fannie Mae and Freddie Mac (the enterprises), to no longer be in effect  but codified several of the code’s provisions. The intent of section 1472  is to better ensure that real estate appraisals used to support creditors’  decisions are based on the appraiser’s independent judgment, free of any  influence from parties that may have an interest in the transaction. Among  other requirements, section 1472 (1) prohibits coercion and bribery to  influence the value of an appraisal, (2) prohibits appraisers from having a  financial interest in property they are appraising, (3) prohibits a creditor  from extending credit if it knows that a violation of appraisal  independence has occurred, (4) mandates that the parties involved in the  transaction report appraiser misconduct to state appraiser licensing  authorities, and (5) mandates the payment of reasonable and customary  compensation for appraisals.
CFPB, FDIC, the Federal Reserve, the Federal Housing Finance Agency  (FHFA), OCC, and NCUA are jointly responsible for implementing the  act’s appraisal provisions. Section 1471 of the act provides the rule- making agencies discretion in exempting certain loans from its  requirements. In their August 2012 proposed rule, the agencies sought comment on whether the final rule should provide an exemption for  certain appraisal requirements for higher-risk mortgage loans made in  rural areas. They also sought comment on whether the final rule should  define “rural” areas as proposed in the ability-to-repay rule. In October  2010, the Federal Reserve issued an interim final rule implementing  section 1472. The Federal Reserve included a safe harbor for  compliance with prohibitions on conflicts of interest for employees and  affiliates of creditors holding less than $250 million in assets. According to  our analysis of SNL Financial data, about 65 percent of community banks  and about 90 percent of credit unions held less than $250 million in  assets in 2011. The agency noted that without allowances for staff and  other limitations of smaller creditors, smaller creditors may decrease their  lending, which could reduce credit availability and harm many consumers.  Further, the agency stated that the federal banking agencies have long  recognized that small institutions may be unable to achieve strict  separation between valuation and loan underwriting staff, and the rule  provides special guidance taking this limitation into account. Specifically,  the interim final rule provides that the appraiser can be employed or  affiliated with the creditor as long as (1) their compensation does not  depend on the value of the appraisal and (2) the appraiser does not  participate in the decision as to whether to make a loan or not.
In their comment letters on the interim final rule, several bank and credit  union associations supported the intent and key aspects of the rule.  However, both a banking and a credit union association suggested that  the safe harbor be expanded to include institutions with less than $1  billion in assets and that hold their loans in portfolio. Specifically, they  noted that many smaller community banks are predominately portfolio  creditors and often make lending decisions based on long-term  relationships and experience in their communities, which would extend to  any valuation activity. CFPB, FDIC, the Federal Reserve, FHFA, OCC,  and NCUA share responsibility for jointly issuing any further final rules on  appraisal requirements under section 1472, as well as implementing  section 1471 and other appraisal provisions.
section_title: Risk Retention Provision Initially May Have a Limited Impact
paragraphs: The Dodd-Frank Act’s risk retention provision for securitizations, found in  section 941 of the act, is expected to have a limited initial impact on  community banks and credit unions largely because of the limited nature  of their current involvement in securitizations. However, as we recently  reported, the implications of section 941 with respect to residential  mortgage lending will depend on a variety of regulatory decisions and  potential changes in the mortgage market that could affect the availability  and cost of mortgage credit and the viability of a private mortgage  securitization market. In turn, such market changes could affect  community banks and credit unions. As discussed in the previous section,  our analysis of SNL Financial data found that over 97 percent of  community banks and over 70 percent of credit unions held residential  mortgage loans in 2011. To securitize residential mortgage loans, lenders  may, in some cases, sell their loans to third parties, generating funds that  they can use to make more loans. The third parties, or securitizers,  bundle mortgages and sell them as investment products, called  residential mortgage-backed securities (RMBS). Securitizers include  investment banks, commercial banks, mortgage companies, and real  estate investment trusts.are (1) Ginnie Mae-RMBS backed by cash flows from federally insured or  guaranteed mortgages, (2) enterprise RMBS backed by mortgages that  meet the criteria for purchase by the enterprises, and (3) private-label  RMBS, which are backed by mortgages that may not meet some aspect   Types of RMBS sold in the secondary market  of enterprise underwriting criteria.expensive for lenders than raising funds directly, and it transfers some or  all of the credit and interest rate risk from the lender to the investors. At  the height of the mortgage boom, as demand for securitization of  mortgage loans grew, lenders and securitizers were increasingly  compensated based on loan volume rather than loan quality, contributing  to a decline in underwriting standards.
Section 941 of the Dodd-Frank Act requires, in part, that mortgage  securitizers retain a financial exposure of no less than 5 percent of the  credit risk of any securitized residential mortgage that is not a “qualified  residential mortgage” (QRM)—that is, one that does not meet certain  underwriting criteria to be defined by the rule-making agencies (FDIC, the  Federal Reserve, OCC, SEC, FHFA, and the Department of Housing and  Urban Development). RMBS have an economic stake in the assets included in the  securitizations they sponsor and, thus, an incentive to help ensure that  lenders originate well-underwritten mortgages. In addition to the  securitization of loans that meet the QRM criteria, the act exempts  securitizations of government-insured or government-guaranteed  mortgages (and certain other assets) from the risk retention requirement  (excluding mortgages backed by the enterprises, which are currently in   Although the purpose and scope of the  government conservatorship).
The Dodd-Frank Act’s risk retention requirement also applies to securities backed by  other asset classes, such as commercial loans, commercial real estate mortgage loans,  credit cards, and automobile loans.
QM and QRM provisions are somewhat different, they could be expected  to work together by increasing lenders’ and securitizers’ exposure to the  risks that are associated with mortgages whose features and terms may  put borrowers at a higher risk of default and foreclosure.
Section 941 requires the rule-making agencies to jointly prescribe  regulations for the risk retention requirement. The Dodd-Frank Act  requires that in crafting the risk retention regulations, the rule-making  agencies must specify, among other things,  criteria for QRMs, taking into consideration underwriting and product  features that historical loan performance data indicate result in a lower  risk of default; permissible forms of risk retention and the minimum duration for whether credit risk is to be allocated from securitizers to loan  the possibility of permitting a lower risk retention requirement (less  than 5 percent) for any non-QRM that meets underwriting standards  that the agencies develop in regulations.
Federal banking and other agencies issued a proposed rule for the risk  retention requirement in April 2011 but have not finalized the rule.proposed rule, the agencies established criteria for QRMs, including that  the mortgage, if made in connection with a purchase, must have a loan-  In the  to-value ratio of 80 percent or less.full guarantee provided by the enterprises would satisfy the risk retention  requirement for securitizations sponsored by the enterprises while they  are under conservatorship with the capital support of the U.S. Department  of the Treasury. Although the Dodd-Frank Act places the responsibility for  retaining risk on securitizers, it permits the agencies to require lenders to  share the risk retention obligations. The proposed rule permits but does  not require a securitizer to allocate a portion of its risk retention  requirement to any lender that contributed at least 20 percent of the  underlying assets to the asset pool underlying a securitization transaction.
The Regulatory Flexibility Act generally requires that an agency, in connection with a  notice of proposed rulemaking, prepare and make available for public comment an initial  regulatory flexibility analysis that describes the impact of the proposed rule on small  entities or certify that the rule will not have a significant economic impact on a substantial  number of small entities (defined in regulations promulgated by SBA to include banking  organizations with total assets of less than or equal to $175 million). aggregated balances of at least $500 million. Accordingly, under the  proposed rule, a securitizer could allocate a portion of the risk retention  requirement to a small banking organization only if the bank originated at  least 20 percent ($100 million based on the above estimate) of the  securitized mortgages. According to the regulators, only one small  banking organization reported an outstanding principal balance of over  $100 million in assets sold and securitized as of September 30, 2010.  Using SNL Financial data, we expanded this analysis to include banks  with less than $10 billion in total assets (our definition of “community  bank”) at year-end 2011. We found that over 890 of these banks  originated loans for securitization, of which 9 reported an outstanding  principal balance of over $100 million in assets sold and securitized,  primarily residential mortgages. NCUA officials said that there is limited  Call Report data on credit unions’ securitization of mortgage loans and  stated that credit unions that do securitize mortgage loans usually sell  their loans to the enterprises. Therefore, under the proposed rule, such  credit unions would not be allocated credit risk because it has been  transferred to the enterprises. Also, under the proposed rule, the  enterprises would be required to retain the risk (and while under  conservatorship, the enterprise guarantee would satisfy the risk retention  requirement).
In our 2011 report, we reported that many industry stakeholders and  consumer groups noted that the implications of the proposed risk  retention rule depend on a variety of regulatory decisions and potential  changes in the mortgage market.characteristics of QRMs that would be exempt from the risk retention  requirement, the forms of risk retention that would be allowed, the  percentage that securitizers would be required to hold, and the risk- sharing arrangements between securitizers and lenders. They noted that  these factors could affect the availability and cost of mortgage credit and   These include decisions on the  the future viability of the private-label RMBS market, which could impact  all institutions involved in mortgage lending. In addition, several mortgage  industry representatives indicated that smaller lenders, such as  independent mortgage companies and small community banks, could  lack sufficient capital resources to share risk retention obligations or hold  non-QRMs that were not securitized on their balance sheets. As we  reported, a few mortgage and securitization market participants told us  that large lenders had the financial capacity to share risk retention  obligations with securitizers or hold non-QRMs on their balance sheets,  giving them an advantage over smaller lenders that could ultimately  reduce competition in mortgage lending. Finally, a number of market  participants noted that even if lenders were not required to share risk in  the manner prescribed by the Dodd-Frank Act, securitizers could be  expected to take steps to transfer the cost of risk exposure by paying  lenders less for the mortgages they sold or requiring additional collateral  to ensure the underwriting quality of the mortgages. But others noted that  creditors would pass this cost on to borrowers and that the cost would  likely be marginal.
In our interviews with state associations, community banks, and credit  unions, officials from 8 of the 16 entities said that the QRM proposed rule  would have a negative impact on community banks and credit unions and  may cause them to decrease their mortgage lending. Five said that it was  too soon to discern the impact of the proposed QRM rule, and three said  the rule would have no impact. One bank noted that the risk retention  requirement would likely curtail the availability of securitizers because of  tighter guidelines for them and limit the bank’s potential market. Officials  from several banks and credit unions said that the risk retention  requirement would not have any impact on their institution because they  did not securitize any of their mortgage loans. One bank official said that  his bank sells its loans in the private market and that its portion of the  securitization is less than 20 percent; thus, the bank would not be  affected by the provision as proposed.
section_title: Other Provisions May Impose Additional Costs or Other Compliance Requirements, but Their Impact Depends Partly on Future Rule Makings
paragraphs: A number of provisions are expected to impose additional costs or other  requirements on certain community banks or credit unions. However, the  extent to which these small institutions will be affected is largely  uncertain, in part because the rules implementing the provisions have not  been finalized.
Few community banks may be directly affected by the Dodd-Frank Act’s  proprietary trading prohibitions, but the federal regulators’ proposed rules  implementing this provision would create additional compliance  responsibilities for community banks. Section 619 of the Dodd-Frank Act,  also known as the Volcker Rule, amends the Bank Holding Company Act  to prohibit banking entities from engaging in proprietary trading and  having ownership interests in hedge funds and private equity funds  (covered funds). The provision’s prohibitions are designed to restrain  risk-taking and reduce the potential for federal support of entities covered  by the provision. To implement the provision, four agencies proposed a  joint rule that was published in the Federal Register in November 2011.  The restrictions and prohibitions in section 619 were to be effective the  earlier of either a year after the issuance of final rules or July 21, 2012. As  final rules have not yet been issued, the prohibitions became effective on  July 21, 2012. Banking and nonbank entities covered by the provision  generally will have 2 years to bring existing activities into conformance.  The act defines proprietary trading as the purchase or sale of securities,  derivatives, commodities futures, or options on these instruments  (covered positions) for the trading account of a banking entity or nonbank  financial entity, as opposed to on behalf of a customer. The act further  defines a trading account as any account used principally with the intent  to profit from short-term price movements. The proposed rule implements  statutory exemptions from the prohibition on proprietary trading for certain  government securities, and for hedging, market-making, and underwriting  activities. The proposed rule also provides guidance on the types of  interests that are considered to be ownership interests in hedge funds,  which commonly are understood to be investment vehicles that engage in  active trading of securities and other financial contracts, and private  equity funds, which commonly are understood to be funds that use  leverage or other methods to invest in companies or other less-liquid  investments.
Our analysis found that few community banks may be affected by the  proposed rule’s prohibitions, but data on proprietary trading and  involvement with covered funds at community banks are limited. Thus,  the exact number of institutions that may be affected by the proposed rule  is unknown. Using SNL Financial data, we found that about 1 percent of  banks with more than $100 million and less than $10 billion in assets  reported having financial instruments that may fall under the definition of  a covered position in their trading accounts at the end of 2011. In  previous analysis conducted on proprietary trading in July 2011, we found  that most proprietary trading has been conducted by the largest bank  holding companies. However, because banks with less than $100  million in total assets or less than $2 million in trading assets are not  required to report their trading assets in Call Reports by the type of  financial instrument, not all community banks involved in proprietary  trading may be captured in the data. Further, Call Reports do not  require banks to report ownership stakes in covered funds, so we could  not estimate the number of community banks that may be affected by this  prohibition.
Despite the small percentage of community banks that may be affected  by the Dodd-Frank Act’s proprietary trading and covered fund  prohibitions, the proposed rules could have an impact on community  banks due to their compliance requirements. The proposed rules have a  tiered compliance program, which was not expressly part of the act but  could apply to all banks. Under the proposed rules, banks that do not  engage in any covered trading or fund activities must ensure that their  existing investment policies and procedures include measures that are  designed to prevent them from becoming engaged in prohibited activities  in the future, for example, by limiting their authorized investments to those  exposures exempt from the prohibition. Banks engaging in covered  activities under the proposed rules must establish a six-part compliance  framework to demonstrate that their activities are allowed by one of the  rules’ exemptions. Specific exemptions also have additional  compliance requirements. For example, to use the exemption for risk- mitigating hedging, banks must be able to demonstrate that their hedging  positions are reasonably correlated with specific risks. Our analysis of  SNL Financial data on over-the-counter (OTC) derivatives found that  about 15 percent of community banks held derivatives for purposes other  than trading, such as hedging risk. The extent to which the risk mitigating  hedging provision may affect community banks will depend on the  requirements or standards that the regulators establish for demonstrating  that a hedge is reasonably correlated with specific risks and whether such  correlations must be on a transaction or portfolio basis. The proposed rule  did not include any specific exemptions from the compliance  requirements for small institutions, so if the proposed rules were adopted,  these banks may have to expand their compliance frameworks to  accommodate any additional hedging requirements imposed by the rule.
Although the impact of the proposed rules’ compliance requirements on  community banks still is unknown, industry associations have expressed  concern that the rules will impose an undue burden on small banks. As  part of the proposed rules, the regulators considered the impact of the  rules on small entities in accordance with the Regulatory Flexibility Act,  and concluded that the compliance requirements in the proposed rule  would not result in a significant economic impact on a substantial number  of small entities. However, one industry association expressed concerns  in its comment letter that the proposed rule will adversely affect  community banks. The association noted that it would be costly for banks  with no covered activities to amend their compliance policies and  procedures, but did not estimate the anticipated increase in compliance  costs for these institutions. The industry association also recommended  that community banks that occasionally engage in interest rate swaps to  hedge their interest rate risk be able to do so without meeting the  compliance requirements for that exemption because these requirements  are more extensive. However, the level of compliance burden may be  relatively small for most community banks, given that the proprietary  trading provisions do not apply to types of exposures that comprise the  investment portfolio of most of the smaller community banks.
The Dodd-Frank Act’s swap provisions under Title VII may impose  additional costs on the fraction of community banks currently using  swaps, but CFTC and SEC have taken steps to help minimize the burden.  A swap is a type of derivative that involves an ongoing exchange of one  or more assets, liabilities, or payments for a specified period. Unlike  exchange-traded derivatives, swaps traditionally have been traded in the  OTC market and generally have not been cleared through  clearinghouses. Financial and nonfinancial firms use swaps and other  OTC derivatives to hedge risk, speculate, or for other purposes, but the  market is dominated by a limited number of dealers. According to the  Financial Stability Oversight Council, OTC derivatives, with the exception  of credit risk transfer products, generally were not a central cause of the  recent financial crisis but were a factor in the propagation of risks, as their  complexity and opacity contributed to excessive risk taking and a lack of  clarity about the ultimate distribution of risks.
Title VII of the Dodd-Frank Act establishes a new regulatory framework  for swaps to reduce risk, increase transparency, and promote market  integrity in the financial system. The act authorizes CFTC to regulate  “swaps,” and SEC to regulate “security-based swaps” (hereafter  collectively referred to as swaps). Among other things, Title VII (1)  provides for the registration and regulation of swap dealers and major  swap participants; (2) imposes clearing and trade execution requirements  on swaps, subject to certain exceptions; and (3) creates record-keeping  and real-time reporting regimes. CFTC and SEC are continuing to  implement Title VII through their rule makings. According to Davis Polk,  CFTC, SEC, and other regulators have finalized 43 of the 90 rules  required under Title VII (as of July 2, 2012).
As shown in table 5, Call Report data aggregated by FDIC show that  1,101 of the 7,250 community banks (15 percent) held derivatives in  2011. According to industry officials, community banks typically use  swaps to manage their exposure to interest rate risk or to help customers  meet their risk management needs. Indeed, banks with $10 billion or less  in total assets held nearly $88.8 million (notional amount) in derivatives at  year-end 2011, of which $82.4, nearly 93 percent, was interest rate  derivatives. Table 5 also shows that a considerably higher percentage of  larger community banks hold derivatives than smaller community banks,  but the use of derivatives within each asset-size class increased over the  past 5 years. In 2011, for instance, over 50 percent of banks with over $1  billion to $10 billion held derivatives, but around 3 percent of banks with  less than $100 million in assets held derivatives. In contrast to community  banks, federally chartered credit unions have been prohibited by NCUA  from engaging in derivatives, except through a pilot program. the Dodd-Frank Act’s clearing requirements and its pilot program  experience, NCUA is reconsidering whether to permit credit unions to  engage in derivatives to hedge risk.
Although permitted by law, NCUA currently allows only a limited number of credit  unions, on a case-by-case basis, to engage in such transactions under an investment pilot  program.
Community bank and other industry officials have raised concerns about  the potential for Title VII provisions or related regulations to impede the  ability of community banks to use swaps. One concern is that community  banks entering into swaps with customers could be required to register as  swap dealers, unless they qualify for an exemption, and therefore be  subject to capital, margin, business conduct, and other regulations. CFTC  and SEC finalized their rule defining, among other things, a swap  dealer. The final rule excludes persons engaged in a de minimis  amount of swap-dealing activity from the definition of a swap dealer.  Based on our analysis of SNL Financial data, we identified over 1,000  community banks that held OTC derivatives at year-end 2011. The data  provided a snapshot of the notional amount of a bank’s derivatives  activity, but did not indicate the value of derivatives entered into in the  previous year, which is needed to determine whether any of the banks we  analyzed met the definition of a swaps dealer. However, the bank with the  highest notional amount of OTC derivatives held around $4.1 billion,  which is considerably below the de minimis amounts set by CFTC and  SEC for CFTC-regulated swaps and SEC-regulated credit default swaps.  In addition, as directed by the Dodd-Frank Act, CFTC and SEC’s rule  excludes from the swap dealer definition banks that enter into a swap with  a customer in connection with originating a loan with that customer and  meet other conditions specified under the rule.
Another concern raised by industry officials is that community banks,  unless exempted, could be required to clear their swaps through a  clearinghouse, which would impose additional costs on them. Title VII  requires those swaps that CFTC or SEC determines must be cleared to  be cleared through a clearinghouse, but provides an exception from the  clearing requirement to end-users that are not financial entities and use  these swaps to hedge or mitigate commercial risk. CFTC and SEC are  required to consider whether to except, among others, small banks and  credit unions from the definition of financial entity and thereby provide  them with an exception from the mandatory requirement. In July 2012,  CFTC adopted a final rule that exempts banks, savings associations, farm  credit system institutions, and credit unions with total assets of $10 billion  or less from the definition of “financial entity,” making such “small financial  institutions” eligible for the end-user exception. As noted above,  community banks’ derivatives activities are limited largely to interest rate  derivatives, which are regulated by CFTC. In December 2010, SEC  proposed rules that would allow small banks and credit unions to use the  end-user exception from mandatory clearing created by the Dodd-Frank  Act.
Even if community banks were provided with an exception from the  mandatory swap clearing requirements, community bank officials are  concerned that their noncleared swaps could be subject to margin  requirements set by CFTC, SEC, or prudential regulators. According to  an industry association, margin requirements could make it difficult or  impossible for many community banks to continue using swaps. CFTC  and the prudential regulators have issued proposed regulations for  noncleared swaps. CFTC’s proposal would not impose margin  requirements on nonfinancial entities. The prudential regulators’  proposal would impose margin requirements on nonfinancial entities but  categorize them as lower-risk, requiring the dealer to collect margin from  a nonfinancial entity only when the dealer’s exposure to the entity  exceeded whatever credit limit the dealer has established for that  particular customer, after evaluation of the customer’s particular financial  repayment capacity.
According to FDIC staff, under long-standing banking agency guidance  that predates the Dodd-Frank Act, a dealer bank engaging in an interest  rate or other derivative with a community bank would not be expected to  collect margin as long as the dealer bank’s exposure to the community  bank was below the credit exposure limits that the dealer bank had  established under its credit assessment processes and procedures. FDIC  staff noted that the joint margin rule proposed by the prudential regulators  reiterates this long-standing interagency safety and soundness guidance  and that the proposed rule would effectively maintain the status quo with  respect to commercial banks that are end-users of interest rate or other  derivatives.
Section 1073 of the Dodd-Frank Act imposes new requirements on  remittance transfers (typically money transferred from consumers to their  families or friends in other countries) that likely will increase costs for  community banks and credit unions, but it also provides some temporary   This provision established new consumer protections  regulatory relief. for remittance transfers, including most electronic wire transfers sent by  consumers in the United States to individuals and businesses in other  countries. In February 2012, CFPB issued a final rule to implement  section 1073 and provided a 1-year implementation period, making the  rule effective in February 2013.providers to provide disclosures and receipts to consumers who provide  the exact price of the remittance transfer, exchange rate, amount of  currency to be delivered, and date of the funds’ availability. In addition,  the rule generally provides that consumers have 30 minutes to cancel a   The rule generally requires transfer  transaction after payment and the ability to dispute errors related to the  transfer. NCUA analysis of Call Report data estimated that about 10  percent of all credit unions offered remittance services in the fourth  quarter of 2011. Although comparable data on remittance services do not  exist for community banks, a recent Federal Reserve study found that  most U.S. depository institutions process international wire transfers on  behalf of their customers.
Industry associations have questioned the ability of institutions that use  open networks to make remittance transfers, such as community banks  and credit unions, to continue to provide such services because of their  difficulty in complying with the rule’s disclosure requirements. These  associations suggested that open network transfer providers be given  regulatory relief. In addition, two industry associations commented that  the final rule does not level the playing field for consumer financial  products, as it favors remittance transfer providers that use closed  networks, such as nonbank institutions. In the February final rule, CFPB  noted that it does not plan to provide an exemption for open network  transfers, because the Dodd-Frank Act clearly covers these types of  transfers.community banks and credit unions, are provided with a temporary   However, insured depository institutions, including  statutory exemption that allows them to provide estimated disclosures for  certain information, including exchange rates and foreign fees and taxes,  in certain circumstances rather than exact pricing. This exemption expires  on July 21, 2015, but CFPB may extend the exemption for an additional 5  years. In addition, to reduce the compliance burden for institutions that  provide remittance services outside of their normal course of business,  CFPB has excluded from disclosure requirements those institutions that  provide 100 or fewer remittance transfers per year.
Officials from 5 of the 12 community banks and credit unions we spoke  with said their institutions offer remittance services, and officials from two  of the four state associations we spoke to said that they have members  that offer remittance services. Of this group, officials from five of the  entities expect that the new remittance transfer rule to decrease their (or  their member institutions’) remittance transfer business. In particular, one  credit union official told us that his institution may exit this line of business  due to the increased disclosure requirements.
Subtitle E of Title IX of the Dodd-Frank Act will provide investors with  more input on executive compensation practices, but may impose  additional compliance requirements on certain publicly traded community  banks and publicly traded companies that hold community banks.  According to the Dodd-Frank Act’s legislative history, Subtitle E of Title IX  is intended to address executive compensation practices that promoted  excessive risk taking.intended to provide shareholders with greater influence over, and insight  into, the activities of publicly traded companies. For example, section 951  requires shareholder advisory votes on executive compensation and  “golden parachutes.” Section 953 requires disclosure of pay versus  performance and the ratio between the chief executive officer’s total  compensation and median total compensation for other employees.  Section 954 requires listed companies to develop and implement   The title contains a number of provisions  clawback policies for incentive-based compensation. Based on our  analysis of SNL Financial data, we identified approximately 200 publicly  traded community banks and approximately 1,200 community banks held  by public companies, some of which may be affected by these  provisions.
Section 951 amends the Securities Exchange Act of 1934 to require  public companies subject to the proxy rules to conduct a separate  shareholder advisory vote on compensation for executives (“say-on-pay”)  at least every 3 years and a vote on the frequency of these votes at least  every 6 years (“say-on-frequency”). shareholder advisory vote on whether to approve certain golden  parachute compensation arrangements in connection with a business  combination. Section 951 provides that SEC may exempt an issuer  from the advisory voting requirements. In determining whether to make an  exemption, SEC is to take into account, among other considerations,  whether the requirements disproportionately burden small issuers.
The JOBS Act further amended the Securities Exchange Act of 1934 to provide that  emerging growth companies—issuers with less than $1 billion in total annual gross  revenues—are not required to seek advisory votes related to executive compensation. associations recommended that community banks be exempted from the  rule because they believe it will add significant burdens. While SEC did  not exempt community banks from the rule, it extended the compliance  date for the say-on-pay and say-on-frequency advisory votes for smaller  reporting companies and newly public companies that qualify as smaller  reporting companies, so that they will not be required to comply until the  first annual or other shareholder meeting occurring on or after January  21, 2013. According to SEC, this deferral served, in part, to allow those  companies to better prepare for implementation of the rules.
Section 953(a) requires public companies subject to the proxy rules to  provide disclosure about pay versus performance, and section 953(b)  requires reporting companies to disclose the ratio between the chief  executive officer’s total compensation and the median total compensation  for all other company employees. that the provision would require complex financial calculations and  potentially expand the universe of persons subject to executive  compensation disclosure requirements. In addition, the association  suggested that SEC should exempt community banks from this provision,  in light of SEC’s recognition that the compensation arrangements at  smaller reporting companies generally are less complex than at other  public companies. SEC has not yet proposed a rule to implement this  provision.
Section 953(a) amends section 14 of the Securities Exchange Act of 1934. In addition,  the JOBS Act further amended the Securities Exchange Act of 1934 to provide that  emerging growth companies are not required to make these disclosures. and could make privately held community banks reluctant to become  publicly traded companies. The industry association suggested that SEC  should exempt community banks from this provision. SEC has not yet  proposed a rule to implement this provision.
The Dodd-Frank Act’s incentive-based compensation provision, section  956, will require a small percentage of community banks and credit  unions to report incentive-based compensation. Specifically, section 956  requires that financial institutions with $1 billion or more in total assets  disclose the structures of all incentive-based compensation arrangements  to their federal regulators. The required disclosures will be used to  determine whether the compensation structure provides excessive  compensation, fees, or benefits, or could lead to a material financial loss  to the institution, which section 956 also requires the regulators to  prohibit. According to our analysis of SNL Financial data, most community  banks and credit unions would not be subject to this provision. Our  analysis indicates that, as of year-end 2011, around 7 percent of  community banks and around 3 percent of credit unions have between $1  billion and $10 billion in assets and, therefore, could be subject to the  provision.
The responsible rule-making agencies jointly issued a proposed rule to  implement section 956 in April 2011, but a final rule has yet to be issued  as of August 2012. Under the proposed rule, financial institutions with  $1 billion or more in assets would be required to report incentive  compensation arrangements annually to their appropriate regulators.  However, pursuant to section 956, specific compensation to individuals  will not be disclosed. Incentive compensation arrangements that  encourage inappropriate risks through excessive compensation or pose a  risk of material financial loss to an institution would be prohibited.  Incentive compensation would be considered excessive when amounts  paid are unreasonable or disproportionate to, among other things, the  amount, nature, quality, and scope of services performed. In addition,  larger financial institutions—such as banks with $50 billion or more in  assets and credit unions with $10 billion or more in assets—would be  subject to additional incentive compensation rules. Incentive  compensation would be deemed to lead to material financial loss unless  the arrangement fulfills certain requirements, including balancing risk and  financial rewards and involving effective risk management and strong  corporate governance.
In their comment letters, industry associations suggested changes to the  proposed rule to benefit community banks and credit unions. One industry  association suggested that the final rule be phased in over a longer time  period for institutions with assets between $1 billion and $10 billion.  Another industry association suggested that institutions with $15 billion or  less in assets with few incentive compensation arrangements should be  required to disclose incentive-based compensation plans once every 2  years, rather than annually, to relieve excessive disclosure requirements  for smaller institutions. Also, several industry associations commented  that the definition of excessive incentive compensation was overly broad  and should be narrowed. Of the 12 banks and credit unions we  interviewed, three of these institutions had more than $1 billion in assets  and may be subject to this rule, and officials from all three of these  institutions told us that they offer incentive compensation. Two officials  expect the proposed rule, if adopted, to have no impact on their  institutions, and the other official said that it was too soon to judge what  the impact would be.
Section 975 of the Dodd-Frank Act requiring the registration of municipal  advisors may or may not affect the majority of community banks,  depending on how SEC interprets “municipal advisor” in its final rule.  Section 975 amended section 15B of the Securities Exchange Act to  require municipal advisors, who previously were largely unregulated, to  register with SEC like investment advisers. Before the Dodd-Frank Act,  some municipal advisors were involved in, among other abuses, “pay-to- play” scandals—that is, influencing the award of business through political  contributions—and recommended unsuitable investments to small  municipalities. Section 975 also authorizes the Municipal Securities  Rulemaking Board to develop professional standards, continuing  education requirements, and business conduct requirements for  municipal advisors. SEC proposed a rule to implement section 975 but  has not yet finalized the rule.that meet the definition of a “municipal advisor” to submit registration  documents to SEC detailing their organizational structure, business  activities, and other information. Further, the proposed rule would require  employees at institutions that meet the definition of a municipal advisor to  register with SEC.
The proposed rule requires institutions  The definition of “municipal advisor” in the proposed rule could cover  many community banks. SEC noted in the proposed rule that the  statutory definition of a “municipal advisor” in the Dodd-Frank Act is  “broad and includes persons that traditionally have not been considered  to be financial advisors. municipal advisors: (1) financial advisors that provide advice to municipal  entities with respect to their issuance of municipal securities and  municipal financial products, (2) investment advisers that advise  municipal pension funds and other municipal entities on the investment of  funds held by or on behalf of municipal entities, and (3) third-party  marketers and solicitors.  ” The rule identifies three general types of  The proposed rule noted that while some types of financial advisors were  exempted in the statutory language, banks were not included in the  exemptions. The proposed rule also notes that every bank account of a  municipal entity is comprised of funds held by or on behalf of a municipal  entity. Thus, if the rule is finalized as proposed, community banks that  provide advice to municipal entities with respect to traditional depository  services could be considered municipal advisors. If community banks  providing such advice to municipal entities are included in the definition of  municipal advisors, community banks and the individual employees that  provide these services would need to register with SEC, who may be a  new regulator for many community banks.
76 Fed. Reg. 824, 828. entities at the end of 2011. In the proposed rule, SEC analyzed the  anticipated initial compliance burden for the registration requirement, and  estimated that the institutions would spend 6.5 hours completing the  registration, on average, and individuals would spend 3 hours, on  average.
In the proposed rule, SEC sought comment on whether the definition of a  municipal advisor should exclude banks to the extent that the bank  provides advice to a municipal entity about traditional banking products,  such as deposit accounts. Industry associations commented that banks  should be explicitly exempted in the proposed rule because their activities  are already supervised by federal and state banking regulators. However,  SEC noted that federal and state banking regulators supervise banks for  safety and soundness purposes and not the quality of the investment  advice they provide to their municipal entity clients. SEC also received  several comment letters from members of Congress who noted that it was  not the intent of Congress to include traditional banking in the definition of  municipal advice. SEC is reviewing the comments it has received as it  develops a final rule, and SEC staff commented that the agency expects  to implement its new oversight responsibilities for municipal advisors after  careful consideration of the comments received.
section_title: Too Early to Determine the Impact of the Dodd-Frank Act on Community Banks’ and Credit Unions’ Small Business Lending
paragraphs: Regulators and industry officials have noted that the full impact of the  Dodd-Frank Act on community banks and credit unions remains  uncertain. Industry officials also have noted that it generally is too soon to  determine the act’s overall impact on community banks’ and credit unions’  ability to lend to small businesses. According to our analysis of SNL  Financial data, almost 90 percent of community banks and about one- third of credit unions held loans to small businesses in 2011. Although  any provision in the Dodd-Frank Act that affects these institutions could  impact their customers (including small businesses), officials from federal  agencies, state regulatory associations, and industry associations we  interviewed identified only one provision in the Dodd-Frank Act  (discussed below) that may directly impact community banks’ and credit  unions’ ability to lend to small businesses. As discussed above,  community banks are important lenders to small businesses. Over the  past decade, community banks have done more small business lending  as a percentage of their total lending than large banks, although large  banks have done more small business lending overall. Small business  lending by credit unions with less than $10 billion in assets has increased  over the past decade from 2 percent to about 7 percent of their total  lending.
Although a number of provisions may ultimately impact lending by smaller  institutions, section 1071 was the only Dodd-Frank Act provision identified  by regulators and industry representatives as potentially having a direct  impact on small business lending by community banks and credit unions.  Section 1071 amends the Equal Credit Opportunity Act to require  financial institutions to collect and report information concerning credit  applications made by women-owned, minority-owned, and small  businesses. The provision serves, among other purposes, to facilitate the  enforcement of fair lending laws. CFPB expects to undertake action to  implement section 1071 in June 2013.
Industry officials and others have expressed concerns about section  1071. According to industry and regulatory officials, the reporting  requirements will increase the costs associated with small business  lending. Industry officials also have noted that the reporting requirements  could lead community banks and credit unions to develop standardized  criteria for their small business lending to avoid being criticized or  penalized by regulators for being discriminatory. They added that such  standardization could then result in less lending to small businesses.  Officials from 12 of the 16 state associations, community banks, and  credit unions we spoke with expect this provision to negatively affect their  institutions or member institutions, and four officials said it was too soon  to tell how this provision would affect their institutions.
We also asked officials from the 16 state associations, community banks,  and credit unions if they expected the Dodd-Frank Act generally to impact  the amount of small business lending conducted by their institutions.  Officials from 11 of these entities told us it was too soon to tell, although  two officials said the Dodd-Frank Act would have no impact. Officials from  three of the entities said that they expected the act to decrease their small  business lending. In our interviews, industry officials also said that the  Dodd-Frank Act provisions cumulatively could increase their compliance  and other costs and adversely affect their competitiveness in the small  business lending market.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to CFPB, FDIC, the Federal Reserve,  OCC, NCUA, SBA, and SEC for review and comment. CFPB and NCUA  provided written comments that we have reprinted in appendices III and  IV.  CFPB and NCUA generally agreed with our report. In addition, CFPB,  FDIC, OCC, and SEC staff provided technical comments, which we have  incorporated, as appropriate. The Federal Reserve and SBA did not  provide any comments.
In its comment letter, CFPB generally agreed with the report’s analysis of  the role played by community banks and credit unions in the economy  and discussion of CFPB’s responsibilities in implementing Dodd-Frank  Act reforms. CFPB further elaborated on the status of its rule makings  related to mortgage reforms and efforts to seek input from small  businesses, community banks, and credit unions about the impacts and  potential alternatives for its rule-making initiatives.
Although generally agreeing with our report, NCUA commented on a  finding that we cited from a GAO report issued in January 2012.noted that it does not believe there is sufficient evidence to suggest that  member business loans pose a higher risk to credit unions or that a key  driver in credit union failures is commercial loans. In our prior report, our  analysis of NCUA’s and its Office of Inspector General’s data indicated  that member business loans contributed to 13 of the 85 credit union  failures from January 2008 to June 2011.
We are sending copies of this report to CFPB, CFTC, FDIC, the Federal  Reserve, NCUA, OCC, SBA, SEC, interested congressional committees,  members, and others. This report will also be available at no charge on  our website at http://www.gao.gov.
If you or your staff have any questions about this report, please contact  me at (202) 512-8678 or evansl@gao.gov. Contact points for our Offices  of Congressional Relations and Public Affairs may be found on the last  page of this report. Key contributors to this report are listed in appendix V.
section_title: Appendix I: Scope and Methodology
paragraphs: Our objectives in this report were to examine (1) significant changes that  community banks and credit unions have undergone in the past decade,  including the factors that have contributed to such changes, and (2) the  Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd- Frank Act) provisions that regulators, industry associations, and others  expect to impact community banks and credit unions, including their small  business lending.
The Main Street Alliance is a national network of state-based small business coalitions.
Financial, a private financial database that contains publicly filed and  financial reports, including Consolidated Reports on Condition and  Income (Call Reports) submitted to FDIC, Thrift Financial Reports  submitted to the Office of Thrift Supervision, and 5300 Call Reports (Call  Reports) submitted to NCUA. We used SNL Financial data to identify  changes in the total number, profitability, lending activities (including  small business lending), expenses, and other metrics of community banks  and credit unions from 2002 through 2011. As regulators do not collect  data specifically on small business lending, we created a proxy for small  business lending using Call Report data on commercial real estate and  commercial and industrial loans for under $1 million for community banks  and member business lending by credit unions. As a result, what we  characterize as small business lending also may include, to some degree,  small loans to larger businesses. We analyzed the data for different asset  classes of community banks (assets of $10 billion or more, $1 billion to  $10 billion, $250 million to $1 billion, $100 million to $250 million, and less  than $100 million) and credit unions (assets of $10 billion or more, $1  billion to $10 billion, $100 million to $1 billion, $20 million to $100 million,  $5 million to $20 million, and less than $5 million). We reviewed the SNL  Financial data and found the data to be sufficiently reliable for our  purposes, and we have relied on the data in our previous reports. We  also interviewed the federal agencies and associations identified above  and four academic and industry experts about trends in the community  bank and credit union sectors and their causes.
To address our second objective, we reviewed the Dodd-Frank Act and  related materials, including relevant congressional hearings; comment  letters on proposed rules; and studies or analysis prepared by federal and  state regulators, industry associations, law firms, and academics. To help  us identify the Dodd-Frank Act provisions applicable to community banks  and credit unions and assess their impact on such institutions, we  interviewed and obtained documentation, when available, from the federal  agencies, state regulatory associations, and industry associations  identified above, and the Bureau of Consumer Financial Protection.   Appendix II contains a table of the provisions identified collectively by  these groups. We also analyzed a number of the Dodd-Frank Act  provisions that regulators, industry officials, and others expect to impact  community banks and credit unions. We used Call Report and other data  compiled by SNL Financial to assess the extent to which community  banks and credit unions may be subject to or otherwise affected by  various Dodd-Frank Act provisions. We took steps to ensure consistency  in data analyses for the various provisions within this reporting section  and determined that any differences in data due to the date on which we  downloaded them from SNL Financial did not have a material impact on  our analysis. Our review of the SNL Financial data also found the data to  be sufficiently reliable for making judgments about the institutions likely  impacted. To obtain further insights into the expected impact of the Dodd- Frank Act, we conducted semistructured interviews with a sample of four  state associations and a sample of 12 community banks and credit  unions. We interviewed two state banking associations and two credit  union associations from Georgia, Illinois, Minnesota, and Pennsylvania,  based on the number and uniformity of community banks and credit  unions within the states. We randomly selected and interviewed eight  community banks and four credit unions from California, Florida,  Massachusetts, Michigan, Ohio, Oklahoma, South Dakota, Texas,  Virginia, and Wisconsin. For selected associations and institutions that  were unavailable to participate, we substituted other similar institutions. In  conducting our interviews, we first sent structured questions by e-mail  and then followed up with in-depth telephone interviews. These interviews  were conducted, in part, to confirm whether the state-level bank and  credit union associations and individual community banks and credit  unions generally considered the same Dodd-Frank Act provisions  identified by regulators, industry associations, and others as potentially  impacting their institutions (or member institutions). These interviews also  provided further insights on the expected impact of the Dodd-Frank Act,  but their responses are not generalizable to the population of community  banks and credit unions.
We conducted this performance audit between February and September  2012, in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
section_title: Appendix II: Provisions of the Dodd-Frank Act Expected by Federal Regulators, State Regulatory Associations, and Industry Associations to Impact Community Banks and Credit Unions
paragraphs: The following table lists the Dodd-Frank Act provisions that are expected  to impact some or all community banks and credit unions. These  provisions were identified primarily based on information we collected  from federal regulators, state regulatory associations, and industry  associations. Industry officials also told us that it is difficult to identify all  of the provisions that may impact small institutions because such  outcomes may depend on how agencies implement certain provisions  through their rules, and many rules have not been finalized. For the same  reason, regulators and industry officials also have noted that enough time  has not passed to assess the full impact of the Dodd-Frank Act on  community banks and credit unions. In particular, the table identifies  provisions that are expected to impact community banks and credit  unions or a subset of these institutions. The table also includes provisions  with explicit exemptions for community banks and credit unions or that  provide regulators with the authority to exempt certain entities or financial  products from a provision.
As discussed in the report, some provisions or exemptions in the act are  expected to have an indirect impact on community banks and credit  unions. For example, section 1024 is expected to have an indirect impact  on community banks and credit unions because it authorizes the Bureau  of Consumer Financial Protection (CFPB) to supervise nonbank financial  institutions. Before the Dodd-Frank Act, nonbank financial institutions  generally were not subject to supervision at the federal level with respect  to the federal consumer financial laws, and CFPB’s supervision is  expected to help level the playing field between these institutions and  regulated institutions, such as community banks and credit unions.
section_title: Appendix III: Comments from the Bureau of Consumer Financial Protection
section_title: Appendix IV: Comments from the National Credit Union Administration
section_title: Appendix V: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Richard Tsuhara (Assistant  Director), Allison Abrams, Jeremy Conley, Stuart Kaufman, Colleen  Moffatt, Patricia Moye, Jennifer Schwartz, Seyda Wentworth, and Henry  Wray made key contributions to this report.