The Fed’s uncertainty about when it will begin to raise interest rates has rekindled interest in the US economy’s historically slow recovery from the 2008 financial crisis and the sharp recession that followed. Up to now, no satisfactory explanation has been given for the slowest recovery in 50 years. Defenders of the Obama administration’s policies have argued that recoveries following financial crises are always slow; conservatives, on the other hand, have tended to blame the heavy, new regulations that Dodd-Frank Act imposed on the financial system in 2010. Recent scholarly work has finally begun to draw a connection between Dodd-Frank and the weak economy of the last six years, and it appears that Dodd-Frank is indeed the culprit.
Dianna Ingram | Bergman Group
First, a study by Michael Bordo and Joseph Haubrich showed that recoveries after financial crises are actually sharper than other recoveries. After studying 27 recession-recovery cycles since 1882, they concluded that “the stylized fact that deep contractions breed strong recoveries is particularly true when there is a financial crisis.” So we should have expected a steep recovery after the sharp 2008–09 recession rather than the stuttering and stalling economy we have experienced.
Also, studies of Dodd-Frank’s effect have shown that the regulatory burdens imposed by that law have been particularly harsh for community banks. The Fed defines community banks as banks with $10 billion in assets or less; 98.5 percent of all US banks fall into this category. A 2012 Government Accountability Office study showed that 7 of the 16 titles in Dodd-Frank had potential adverse effects for these banks, and studies by scholars at George Mason University and Harvard’s Kennedy School have found significant compliance cost increases attributable to Dodd-Frank. “Since the second quarter of 2010,” said the Harvard study, “around the time of [Dodd-Frank’s] passage, we found community banks’ share of [US banking] assets has shrunk drastically—over 12 percent.”
Of course, the regulatory costs to community banks are not a new story; Congress has been attempting to mitigate these costs for years. What is new is the data that shows the effect of these regulatory costs on small business and hence on economic growth.
We are dealing with a part of the US economy that does not get a lot of attention in the media, so some numbers are in order. According to the US Small Business Administration (SBA), a small business is one that has fewer than 500 employees. There were approximately 23 million small businesses in the US in 2012, of which approximately 5 million were employers—amounting to 99.7 percent of all employer firms. The rest are sole proprietorships (mom and pops) that have no formal employees. In contrast, again according to the SBA, 18,500 firms in 2010 had more than 500 employees and were not thus counted as small firms.
Where do these two classes of businesses—large and small—get their financing? Approximately 10,000 firms were registered with the Securities and Exchange Commission (SEC) in 2014, virtually all of them businesses with more than 500 employees. Registration with the SEC means that these firms have access to financing in the capital markets that have been largely unaffected by Dodd-Frank. But small businesses—almost all the 23 million small firms, including 5 million small-business employers—were required to rely primarily on banks for their credit needs.
Thus, we have a peculiarly bifurcated economy. The vast majority of employers need banks for financing, while a small number of large firms has access to credit in the capital markets because they are large enough to register with the SEC and finance themselves through the issuance of bonds, notes, and commercial paper.
This is where the costs loaded on small banks begin to affect US economic growth. Regulatory costs affect small banks more than large banks because the costs are largely fixed and large banks by definition have a bigger asset base over which to spread these costs.
When a small bank is required to hire a compliance officer, that is an employee who is not making loans or producing revenue. When the Consumer Financial Protection Bureau—set up by Dodd-Frank and the bane of small banks—sends out a 1,099-page regulation on mortgage lending, that means a community bank must engage a lawyer to interpret the new regulation, a compliance officer to apply the regulation in individual cases, and a tech firm to retool its mortgage underwriting system. All costs, no revenue, and fewer funds to lend. When a bank examiner criticizes a loan because the bank does not have audited financial statements for a customer who has never missed a payment in 20 years, that forces a bank to revise its business model and change its customer relationships. Again, costs for the bank and less financing for the small business.
If the costs Dodd-Frank has imposed on small banks are hurting small business, we should see a significant difference between the growth rates of small and large businesses since 2010. That is exactly what the data shows. In a Goldman Sachs report published in April 2015 and titled “The Two-Speed Economy,” the authors found that firms with more than 500 employees grew faster after 2010—the year of Dodd-Frank’s enactment—than the best historical performance over the last four recoveries. These firms largely had access to the capital markets for credit. However, jobs at firms with fewer than 500 employees declined over this period, although this group had grown faster than the large-firm group in the last four recoveries.
Here, then, is the source of the slow recovery from the 2008–09 recession. Although 64 percent of net new jobs in the US economy between 2002 and 2010 came from employment by small business, this source of growth has disappeared since the enactment of the Dodd-Frank Act. While larger firms have access to credit in the capital markets, millions of small firms, limited to borrowing from beleaguered community banks, are not getting the credit they need to grow and create jobs.
More on the Dodd-Frank Act from AEI’s Economic policy team
Peter J. Wallison is a senior fellow at the American Enterprise Institute. His most recent book is “Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again” (Encounter, 2015).
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