When the Dodd-Frank Wall Street Reform and Consumer Protection Act was first passed in the summer of 2010, there was a lot of speculation about what impact the wide-ranging legislation might have on the community banking industry.

Some pundits opined that Dodd-Frank sounded the death-knell for community banks by raising capital and equity requirements, increasing regulatory burdens (and costs) and limiting how much banks can charge merchants in interchange fees, thus lowering non-interest fee income. (Note: While banks with less than $10 billion in assets are exempt from the limitation on interchange fees, these banks may be forced to lower their interchange fees to compete with larger banks.)

Nearly two years have passed since Dodd-Frank became law, during which time many of the law’s provisions have been implemented and started to take effect. This makes now a good time to reassess the question: What will Dodd-Frank mean for community banks?

Impact on Profitability
There’s little (if any) doubt that Dodd-Frank will have a negative impact on bank profitability. Higher capital requirements combined with lower income and higher compliance expenses will result in a lower return on equity (ROE) for most community banks. (See the chart below for a DuPont analysis of bank profitability.)

So the question becomes: What level of return will bank investors be willing to accept? In one survey, investment bankers and financial industry consultants estimated that the provisions of Dodd-Frank would lower the ROE of community banks with less than $500 million in assets to between 6 percent and 8 percent. However, bank investors generally look for returns in the 11 percent to 14 percent range.

All things being equal, if a bank has to maintain more capital, it will have to earn more money on every dollar of revenue it generates and every dollar invested in assets in order to maintain the same ROE. To do this, return on assets (ROA) must go up.

Bank revenue is driven primarily by interest and non-interest margin. Community banks have traditionally generated interest income through residential mortgages, acquisition and development (A&D) and construction loans, and commercial real estate (CRE) loans. However, a number of factors, including regulatory caps on CRE and construction loans as a percentage of capital, will likely reduce these sources of revenue.

Interest expenses, meanwhile, may rise in the future due to new disclosure and reporting requirements (like the new small business reporting requirements that are similar to HMDA), new lending non-discrimination rules and the repeal of Reg Q. On the non-interest side, income (which consists primarily of fees) will likely fall due to the factors noted above, while non-interest expenses (including incremental compliance costs) will probably rise.

What It All Means
All of this adds up to one inescapable conclusion: Lower revenue, higher capital requirements and higher costs are likely to adversely impact bank profitability in the future. And community banks are especially vulnerable because they usually don’t have the scale and alternative sources of fee income across which they can spread incremental compliance costs.

The net result will likely be consolidation of community banks. Banks with less than $1 billion in assets will find it especially difficult to remain independent in the post-Dodd-Frank world.

Some community banks will be forced to either go into acquisition mode or be acquired themselves. Many expected this shakeout to start last year, but it hasn’t materialized yet. This is primarily due to the fact that bank stocks remain depressed, and there’s still a disconnect between buyers and sellers.

Many sellers believe their bank is worth 1.5x–2x book value, when in reality, it may not even be worth book value. And buyers remain suspicious of the quality of bank earnings – and they realize that it’s a buyer’s market now, and likely will stay that way for the foreseeable future.

Survival in the post-reform banking world requires a strategic plan. Please give us a call if you’d like to discuss your bank’s plans in more detail.