While the Dodd-Frank Wall Street Reform and Consumer Protection Act will affect all banks, large and small, this Alert explains the following effects that the act will likely have on community banks.

Interchange Income

The act amends the Electronic Fund Transfer Act (EFTA) by inserting language regarding reasonable fees and rules for payment card transactions. The new language states that the Federal Reserve Board “may prescribe regulations ... regarding any interchange transaction fee that an issuer may receive or charge with respect to an electronic debit transaction.” The act goes on to state that the amount of any interchange fee “shall be reasonable and proportional to the cost incurred by the issuer with respect to the transaction.” The board is required to prescribe final regulations establishing standards for assessing whether an interchange fee is reasonable and proportionate to the cost incurred by the issuer no later than nine months after enactment of the Dodd-Frank Act. The act states that the board may allow adjustment of the interchange fee for costs incurred by the issuer in preventing fraud.

Small issuers have an exemption from the provision of the act regarding the restrictions on interchange fees. The restriction on interchange fees does not apply to issuers that, together with affiliates, have assets of less than $10 billion. Although smaller institutions are exempt from the interchange restrictions of the act, it is likely that these smaller institutions will be forced to lower their interchange fees due to market pressures. Customers will likely leave institutions that charge higher fees for institutions that are charging lower fees. As such, smaller institutions will be forced to lower their fees and subsequently this source of income will be curtailed. Smaller institutions will need to find ways to replace this income or learn to survive without it.

Consumer Financial Protection Bureau

The act creates a new regulatory body that will be known as the Bureau of Consumer Financial Protection (CFPB). The CFPB will be responsible for implementing and enforcing federal consumer financial law consistently to ensure that all consumers have access to markets for financial products and that the market for consumer financial products and services are fair, transparent and competitive. The CFPB will have the authority to promulgate regulations applicable to banks of all sizes with respect to consumer financial law. The CFPB, however, will only have examination and enforcement authority over banks with assets of more than $10 billion.

The CFPB has the potential to become one of the most powerful agencies in the United States, and its rulemaking authority extends to financial institutions of all sizes. The regulations that the CFPB issues could result in additional regulatory costs for community banks. Although the CFPB will not serve as the primary regulator of small banks for purposes of consumer financial law, it will have the ability to directly affect small banks in addition to its rulemaking authority. The CFPB has the authority to require, from banks with $10 billion or less in assets, reports that it determines necessary to support its examination activities and assess and detect risks to consumers and consumer financial markets. Additionally the CFPB may include its examiners on a sampling basis of the examinations of the primary regulator of an institution with $10 billion or less in assets. Overall, the CFPB could significantly increase the regulatory costs of all banks, including community banks.

Mortgage Reform

Title XIV of the act introduces a number of reforms that will have an impact on mortgage origination. The act imposes new regulations on mortgage originators and establishes new disclosure requirements by amending the Truth in Lending Act. The act restricts the provision of incentives for steering consumers into higher-cost mortgage loans. The act also sets minimum underwriting standards for mortgage loans and creates a mortgage originator duty of care. The act also places prohibitions on certain prepayment penalties and lowers the threshold for loans subject to the Home Ownership and Equity Protection Act. Additionally, the act establishes appraisal requirements for higher-risk mortgages and has several other effects on appraisals. Overall, the act will have a significant, and potentially costly, impact on community banks. The CFPB will be responsible for implementing regulations with respect to the issues discussed in Title XIV. Community banks should play close attention to the rules and statements that come from the CFPB regarding mortgages to ensure they remain in compliance with the act and subsequent regulations.

Weakened Preemption

The Dodd-Frank Act changes the standard for the preemption of state law. The act returns to the standard enunciated in Barnet Bank v. Nelson, 517 U.S. 25 (1996). The act indicates that state consumer financial laws are only preempted if application of such law would have a discriminatory effect on national banks in comparison to the effect on state banks or the state law “prevents or significantly interferes with” the exercise by the national bank of its powers. This change in the preemption standard could cause uncertainty for community banks, as they could become subject to state laws that were previously preempted. An increase in regulatory uncertainty usually leads to an increase in compliance costs. As a result of the new preemption standard, community banks should be prepared to use additional resources to comply with state laws.

New Capital Standards

The Dodd-Frank Act eliminates trust preferred securities as an element of Tier 1 Capital for large bank holding companies. Fortunately, however, small bank holding companies with less than $500 million in assets that are not engaged in significant nonbanking activities, do not conduct significant off-balance sheet activities (including securitization and asset management), and do not have a material amount of debt or equity securities outstanding (other than trust preferred securities) are exempt from this restriction. These small bank holding companies are exempt from the phase-in requirements regarding regulatory capital deductions of trust preferred securities issued before May 19, 2010 and the post-May 19, 2010 restriction on the use of trust preferred securities as part of Tier 1 capital. Also, bank holding companies with less than $15 billion in total assets are exempt from the phase-in requirements regarding regulatory capital deductions of trust preferred securities issued before May 19, 2010.

New FDIC Insurance Rules

The Dodd-Frank Act changes the assessment base for FDIC deposit insurance. The new assessment base will be tied to total assets less tangible equity instead of deposit liabilities. The likely effect of this will be to increase assessment fees for institutions that rely more heavily on nondeposit funding sources. Many in the banking industry believe that this change will increase assessment rates for large banks and lower assessment costs for smaller community banks. In general, community banks usually derive the majority of their funding from deposits, so the assessment rates for such institutions should not increase and could decrease. However, the higher assessments for institutions that have relied on nondeposit sources of funding in the past could force these institutions to change their funding models and more actively search for deposits. If this happens, it could drive up the costs to attain deposits across the market, a situation that would negatively impact community banks.

The act also changes the minimum reserve ratio for the FDIC deposit insurance fund. The act increases the minimum reserve ratio to 1.35 percent of estimated insured deposits or the assessment base. The FDIC is required to offset the effect of the increased minimum reserve ratio for banks with assets of less than $10 billion, so smaller community banks will be spared the cost of funding the increase in the minimum reserve ratio. It is not clear how the FDIC will offset the effect of the increased minimum reserve ratio for banks with assets of less than $10 billion. The FDIC could charge the same assessment rates to both large and small banks until the insurance fund reaches the previous minimum reserve ratio of 1.15 percent and then charge higher rates to larger banks to bring the ratio up to the new 1.35 percent threshold. It is likely that once the insurance fund reaches the new minimum reserve ratio, banks of all sizes will be required to maintain the insurance fund above that ratio. This could impact the assessment rates of community banks in the future. Community banks will need to monitor announcements from the FDIC to determine how it will shield them from the cost of reaching the new minimum reserve ratio.

Finally, the Dodd-Frank Act permanently increases the amount of deposit insurance available per customer from $100,000 to $250,000. Community banks should change all of their signage and disclosures to reflect this permanent change.

Expanded De Novo Branching Authority

The Dodd-Frank Act expands the authority of banks to engage in interstate branching. The act allows a state or national bank to open a de novo branch in another state if the law of the state where the branch is to be located would permit a state bank chartered by that state to open the branch. The expanded interstate branching authority could have positive and negative impacts on community banks. On the positive side, if a community bank is looking to expand into a neighboring state the act could allow them easier access into the neighboring state. On the negative side, it could lead to increased competition from regional or national banks that use the expanded authority granted by the act to establish branches in states where they otherwise would not have, if not for the Dodd-Frank Act.

Miscellaneous Laws and Regulations

The Dodd-Frank Act makes numerous changes to existing laws and regulations that will have an impact on community banks. For example, the act amends the Expedited Funds Availability Act and increases the minimum next-day availability requirement for deposits made by check from $100 to $200. The act also requires the minimum amount available on the next day to be adjusted every five years. While not a very major change, this will nonetheless require community banks to update and change programs that determine funds availability. The change will also benefit banks by increasing deposit levels for next-day availability.

The act also increases the amount of information that banks will need to report in accordance with the Home Mortgage Disclosure Act of 1975 (HMDA). Among the additional pieces of information that banks must collect are the ages of borrowers, the credit scores of borrowers, total points and fees payable at origination, the difference between the annual percentage rate associated with the loan and a benchmark rate or rates for all loans, and the value of the property pledged as collateral. As is the case with the act’s other effects on community banks, complying with these types of provisions will require community banks to expend additional resources and will ultimately increase the banks’ operating costs. The CFPB ultimately will have the final say as to how these provisions of the act should be implemented, and, as such, commercial banks should pay attention to any comments or rules that come from the CFPB.