On March 26, 2016, The Economist published an article entitled “The Problem with Profits.” That article discussed the high profitability of U.S. firms and why that seemingly positive fact is actually harmful to the overall economy, mainly because those profits are not being distributed for spending by shareholders or reinvested in business growth. As a result, the economy shrinks as resources flow to these firms and remain on their balance sheets. The focus of the article was a call for increased competition, but we believe we should focus on other conclusions.
While the article gives a tip of the cap to the impact of regulation generally and bank regulation specifically, banks represent the poster child for the negative impacts of limiting the ability of domestic firms to reinvest, an impact that is not directly reflected on balance sheets or income statements.
Since the onset of “new and improved” regulation stemming from Dodd-Frank and other regulatory reforms, we are seeing are clients use their resources to
- hold capital on their balance sheets, in some cases to protect against the anticipated negative impacts of an imaginary doomsday scenario;
- retain “high quality liquid assets;”
- invest in extraordinary compliance expertise and management systems; and
- fill buckets left empty from reduced interchange fees, the impact of stress testing, and higher costs to originate mortgage loans, among other things.
As an industry, we frequently point to decreased lending to small businesses and increased consolidation as the evils of increased regulation. In our view, however, the dampening of reinvestment initiatives is much more significant for the industry and for the economy in general.
Consolidation, standing alone, is healthy for the industry in that it offers opportunities for increased efficiencies and allows shareholders of selling institutions to monetize their investments at a control premium. The problem, however, is that the benefits of consolidation are not being used purely for growth and innovation (although certainly a portion of those benefits are being used in that fashion) but rather dedicated to addressing one or more of the four points above. Look no further than the private sector’s relative dearth of interest in creating new banks for a prime example of where the benefits of consolidation are NOT flowing.
Of course, banks should be credited for their efforts in attempting to address the strain on resources for reinvestment. As The New York Times discussed, a report from Citigroup projects future utilization of financial technology as a path to increase efficiency, thereby creating reinvestment resources. Indeed, the success of the fintech industry is largely driven by creating mechanisms to capture financial transactions and relationships without a great deal of investment. For that reason, we strongly suggest banks of all sizes explore partnerships with financial technology companies, and it is no surprise that excessive regulation can lead to partnerships with largely unregulated firms. Unfortunately, a consequence of steering resources to virtual delivery channels is a reduction in direct job creation by banks, particularly in non-metro markets.
The premise of regulation is that it is appropriate to allow government agencies to interfere with private businesses for the overall greater good. Banks, in addition, are extended the benefit of lower cost funding through FDIC insurance, which is the theoretical basis for the bank regulatory framework. With that said, there should always be healthy debate about where to draw the line between protecting the public and allowing free enterprise to proceed. We believe the banking industry is at its best when it is growing and innovating, providing jobs of its own and financing the creation of new jobs in other industries. Today, regulation is an undue hindrance to achieving those benefits for the overall economy.
The macroeconomic implications of limiting reinvestment through excessive regulation are staggering. The next time you are confronted by an economist, senior regulator, or politician telling you that new regulations are helping banks given the increased profitability of the industry, confront them with the overall implications of limiting reinvestment by banks in their own success. This type of “big picture” academic discussion is their native tongue.