The Effects of the Dodd-Frank Act on Community Banks

By David W. Powers

The stated objectives of the Dodd–Frank Act (DFA) include promoting the financial stability of the United States by improving accountability and transparency in the financial system, ending "too big to fail," protecting the American taxpayer by ending bailouts and protecting consumers from abusive financial services practices. Much of the attention has focused on the act’s requirements for larger institutions; however, as the implementation of DFA unfolds, discussion related to how its provisions will affect community banks has increased. Many in the industry are concerned about how the requirements will apply to community banks and believe that the focus should remain on larger institutions that pose greater systemic risk. This article looks at how community banks are affected by some of these provisions, including Debit Interchange, Stress Testing, FDIC Insurance, Capital Requirements, Charter Conversions and Savings and Loan Holding Companies (SLHCs).

Debit interchange rules — implemented by the Board of Governors of the Federal Reserve System through the issuance of Regulation II, Debit Card Interchange Fees and Routing — establish standards for reasonable debit card interchange fees and prohibit network exclusivity arrangements. Institutions with assets less than $10 billion are exempt. Visa and MasterCard set two-tiered pricing for those regulated (more than $10 billion) and those not regulated; however, some industry members believe the interchange-tiered pricing is temporary and, once removed, will force community banks to compete with big bank card issuers, thus losing a revenue source. While the market may gravitate toward low-priced products, banks must differentiate their products and demonstrate why they are better for the consumer.

Stress testing practices at banking organizations with consolidated assets of greater than $10 billion must adhere to supervisory guidance that the federal banking agencies issue in accordance with the act. The purpose of the proposed guidance is to emphasize the importance of stress testing in equipping banking organizations to assess the risks they face and address a range of potential adverse outcomes. The recent financial crisis underscored the need for banking organizations to conduct stress tests to help prepare for events and circumstances that can threaten their financial condition and viability. As noted in our spring 2012 edition of S&R Perspectives, there are no explicit expectations for stress testing at banking organizations under $10 billion in consolidated assets, other than those already required, such as for commercial real estate and liquidity and interest rate risk; however, it is a tool that can assist with key business and risk management decisions at institutions of all sizes.

FDIC insurance changes expand the insurance coverage, increase the reserve ratio and alter the assessment calculation, requiring large banks to foot much of the bill. The act permanently increases the FDIC deposit insurance per depositor from $100,000 to $250,000, and grants an extension of unlimited deposit coverage for noninterest-bearing transaction accounts for two years, expiring January 1, 2013. The changes to the insurance coverage increase the potential exposure of the deposit insurance fund while bolstering confidence in the banking system and providing community banks an opportunity to maintain deposits when competing with large financial institutions, money market funds and money management companies.

Along with the increase in exposure from the expanded insurance coverage, the minimum reserve ratio for the Deposit Insurance Fund increases from 1.15 percent to 1.35 percent, but the act exempts institutions with assets of less than $10 billion from the cost of the increase. The assessment base for deposit insurance has changed from domestic deposits minus tangible equity to average consolidated assets minus average tangible equity. As a result, larger financial institutions, which utilize more nondeposit liabilities, will pay a greater percentage of the aggregate insurance assessment. Smaller banks will pay less than they would have — perhaps as much as $4.5 billion less over the next three years. A potential unintended consequence is an increase to cost of funds if the larger financial institutions shift their funding structure away from nondeposit sources when the cost of the assessment is greater than the interest charge for deposits.

Capital requirements are more stringent with the implementation of DFA. This is to ensure that sufficient capital is held to absorb losses during future periods of financial distress and to reduce the use of taxpayer-funded bailouts of financial companies. Under the Collins Amendment, trust preferred securities of bank holding companies (BHCs) issued before May 19, 2010, continue to count as Tier 1 capital for entities with less than $15 billion in total assets. Additionally, BHCs with assets of less than $500 million are exempt from the Collins Amendment, allowing these institutions to issue new trust preferred securities that will count as Tier 1 capital.

Another change with capital implications is in the definition of “accredited investor” — for the next five years, the net worth calculation for determining an accredited investor is $1 million, excluding the value of a primary residence. Previously, there was no such exclusion, so will this restriction reduce the number of local investors for community banks? After five years, the Securities and Exchange Commission is required to adjust the $1 million threshold for inflation. Community banks engaged in capital raising activities must amend the definition of “accredited investor” to conform. This may limit the pool of potential investors for raising private capital.

DFA requires holding companies of banks and thrifts to serve as a source of financial strength for any subsidiary that is a depository institution. This generally refers to the holding company’s ability to provide financial assistance in the event of financial distress. Furthermore, the federal banking agencies must establish minimum leverage and risk-based capital requirements on a consolidated basis for BHCs and SLHCs that are not less than generally applicable requirements. This is interpreted as being well-capitalized based on Prompt Corrective Action requirements. The Federal Reserve's policy on small BHCs (those with assets of less than $500 million) was preserved, exempting them from the consolidated capital requirements; however, small SLHCs are not exempt from the consolidated capital rules.

Charter conversions are prohibited for changes between national and state charter status if the entity is subject to a formal enforcement action or memorandum of understanding with the current bank supervisor. DFA allows for an exception to this restriction if the proposed new supervisor gives written notice to the current supervisory agency of the proposed conversion plan to address the significant supervisory matters under the action. If acceptable to the current supervisory agency, the charter change can move forward. Although DFA does not apply for conversions between member and nonmember status, the basic concept is expected to be applied in practice.

Savings and loan holding companies transitioned to the oversight of the Federal Reserve System on July 21, 2011. Since then, the Federal Reserve has issued Regulations LL and MM, two interim final rules addressing SLHCs and mutually owned SLHCs, and several supervisory letters that are similar to Office of Thrift Supervision CEO memorandums covering the supervisory process, regulatory reporting and decertification as an SLHC. Additional guidance is expected in 2012 on regulatory capital requirements, as well as potential updates to Regulation LL and MM based on comments submitted.

While this article only touches on a few of the provisions, it should provide community banks with a perspective on the implementation of the Dodd-Frank Act. The regulatory agencies created numerous workstreams to develop the requirements DFA prescribed. As the Board of Governors of the Federal Reserve System issues related supervisory guidance, the intent is to minimize undue regulatory burden and assist banks, particularly community banks, in understanding how DFA applies.

Further information can be found in the following guidance:

Regulation II

Regulatory Reform

Regulation LL

Regulation MM

David W. Powers is a supervisory examiner for SLHC supervision with the Federal Reserve Bank of Richmond. He can be reached at

The analyses and conclusions set forth in this publication are those of the authors and do not necessarily indicate concurrence by the Board of Governors, the Federal Reserve Banks, or the members of their staffs. Although we strive to make the information in this publication as accurate as possible, it is made available for educational and informational purposes only. Accordingly, for purposes of determining compliance with any legal requirement, the statements and views expressed in this publication do not constitute an interpretation of any laws, rule or regulation by the Board or by the officials or employees of the Federal Reserve System.

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