Too small to be compliant?
Size and scale economies in the compliance cost structure of Italian banks
Simona Cosma
University of Salento
SDA Bocconi School of Management
Via Monteroni -
73100 Lecce - Italy
Tel. 3286535183
-
Gianfausto Salvadori
University of Salento
Provinciale Lecce-Arnesano P.O.Box 193 I
73100 Lecce (Italy)
+39 0832 297584
Paola Schwizer
University of Parma
Via J.F. Kennedy 6
43100 PARMA (I)
Tel. +39.335.6214271
Abstract
The enormous legislative activity, that has characterized the banking system in recent years, has forced banks to support substantial costs to ensure regulatory compliance.
The significance of these costs is highlighted in many researches that show, respectively, the incidence of start-up and on-going costs on bank operational expenses.
An excessive increase in the cost of compliance could result in an increase in the cost of banking services to end-users.
Should there be economies of scale, smaller banks would have higher mean costs for compliance than the larger ones and this could encourage outsourcing of compliance activities or, to a point, mergers and acquisitions.
Although in the past several studies have tried to quantify the cost of regulatory compliance and to verify the existence of economies of scale in this activity, no studies deal with this issue with respect to the Italian contest.
The present work provides the magnitude of compliance costs and a first insight into the existance of scale economies using data on the start up compliance costs collected by the Italian Banking Association (ABI) ever since legislation on banking and financial transparency came into force.
The analysis also emphasizes the relationship between the strength of the scale economies and the bank size.
This paper is the first output of the research: the next step is analyse the effects of other legislations in a larger sample.
1. Introduction
The banking industry is the most heavily regulated industry because of the nature and role it plays in the financial and economic system. The enormous legislative activity that has characterized the banking system in recent years, the evolution of which is still on-going, if on the one hand it has focused on strengthening the protection of "weak contractors" as well as the overall stability and the development of competitive conditions that are the same for international banks in different countries, on the other hand, it has forced banks to support substantial costs to ensure regulatory compliance. The significance of these costs are highlighted in many research that show, respectively, the incidence of start-up and on-going costs on bank operational expenditures.
As clearly emerged in the 2008 investigations carried out by the Center for the Study of Financial Innovation, there is concern for the increased costs of compliance that regulated entities and supervisory Authorities sustain. This shows up from the greater importance that is assigned to the analyses of cost-benefit and quantitative impact or by definite initiatives carried out to streamline the regulatory framework started up by the Financial Services Authority, FSA.
From a broader perspective, the evaluation of the cost of regulatory compliance compared to the generated benefits is being examined by the European Community under "Better regulation approach". According to Italian law n.229/2003 and law n.262/ 2005, for each regulatory act even Banca d’Italia has to carry out an impact assessment on the markets, on the activities of enterprises, on the operators and on the interests of the consumers/savers.
The first pilot case of impact analysis has focused on the legislation of banking and financial transparency.
The regulatory attention to costs of compliance and the criticality of these for the banking industry have brought awareness to understanding the magnitude and what determines these costs and the possible effects on banks of different sizes.
An excessive increase in the cost of compliance could result in an increase in the cost of banking services to end-users.
Should there be economies of scale, smaller banks would have higher mean costs for compliance than the larger ones: the economies of scale, in fact, arise from the existence of input factors that are undividable, i.e. that may not be used in smaller units.
The existence of economies of scale in the activity of regulatory compliance could result in:
· a distortion of the level playing field as a result of possible entrance barriers linked to a initial physiological low output, or the possible inhibition of competition, in specific sectors and on specific products if the economies of scale concern specific regulations,
· a change in the market structure by stimulating the process of consolidation in a few large banks.
Although in the past several studies have tried to quantify the cost of regulatory compliance and to verify the existence of economies of scale in this activity, in Italy there are no studies on this issue.
This study is the first attempt to analyze the extent and the determinants of the costs of regulatory compliance for Italy. This study focuses, in particular, on the costs of compliance ever since legislation on banking and financial transparency came into force because it represents the first pilot case of timely recognition by the Italian Banking Association (ABI) of costs incurred by the Italian banks to comply with the new legislation.
The research questions to which this work will try to provide an answer are the following:
1. What are the mean incremental costs incurred by Italian banks as a result of new legislation on transparency?
2. For the purposes of regulatory compliance, which activities take up the greater percentage of the costs?
3. Are there economies of scale in the activity of regulatory compliance?
4. To what extent does the size of the bank affect the incremental costs incurred?
2. Literature review
A literature review on the costs of regulatory compliance reveals an abundance of studies from academia or commissioned by Supervisory Authorities. In these studies, the following methodologies are use to estimate the costs :
· case studies that can provide detailed and reliable results, but are not broad-spectrum;
· surveys, which allow to obtain wide-ranging results but that are relatively reliable for their shortcomings in terms of control over the implementation of the acquisition of the necessary information by the entity in charge of the response and the proper understanding of the questions; they have proved to be more appropriate for the investigation of the effects of one or a few consumer regulations;
· econometric studies: not widely used because of the difficulty in isolating the effect on costs due to the regulation from those ones due to other variables (in both cross-section and time series analyzes) (Benston 1975, Mitchell, Cowling, Crane, Spong et al. 2008, Piatti 2009);
· studies by analogy: these take into consideration the costs and time necessary to estimate the costs of compliance but the achieved results are uncertain because of the difficulty of identifying valid similarities for the regulation that is being studies (Smith 1977, Baer 1988, Hannan 1989).
This paper presents the results of some important studies on the compliance costs distinguishing on the basis of the methodology used to estimate these costs.
The case study methodology has been used by Darnell (1980) to investigate the total on-going operating costs that had to be sustained to fulfil all the American federal standards, national and local in the USA in 1979. The case in study is a commercial bank with total assets of 1.6 billion dollars. The author estimates total on-going costs for 6.2 million, i.e. 13.7 % of operating costs and costs for the "Consumer regulation" equal to 5.9 % of operating costs.
McKinsey & Co (1992) seek on-going incremental costs for 60 regulations intended solely to institutions insured by FDIC. They analyze four commercial banks in 1991 and estimate incremental on-going costs equal to 6.1 % of the operating costs and costs for the Consumer regulation equal to 0.8 % of operating costs.
Grant Thornton (1992) attempts to quantify the total repeated operating costs in 1991 needed to fulfill 13 regulations (the most expensive) and examines 9 community banks with assets ranging from 17 to 221 million dollars. The on-going operating costs come to 14.2 % of operating costs and consumer regulation result in 8.6 % of operating costs.
Grant Thornton (2002) proposes two objectives:
1. to compare the cost of the Community Reinvestment Act (CRA) between two community banks belonging to the same holding company (with total assets of less than 1 billion) and to identify the differences between the costs incurred by the “large” bank (asset > 250 million) compared to the "small" one.
2. to identify the areas in which the costs of regulatory compliance show a considerable increase in banks that change status (from total assets < 250 to > 250 million) and display further disparities between large and small community banks in the CRA examination procedures. The case studies are two community banks: respectively a "small" and a "large" one, and a community bank that goes from "small" to "large". The results indicate that the "large" bank has total assets equal to twice those of the "small" one, and has six times more staff working part-time on CRA compliance. The "large" bank has operating costs for CRA that are four times higher than those of its "small" counterpart ($92.500 versus $19.000). The community bank that goes from "small" to "large" status has a 1000% increase in operating costs for the CRA - from $7.000 to $75.000 per year and $150.000 of start-up costs.
The survey method has been adopted by Grant Thornton (1993) for ICBA to estimate the aggregated costs of compliance for 13 regulations on 765 independent banks (from 43 to 83 for each regulation). Total on-going costs were equal to 12.6 % of operating costs.
Credit Union National Association (Joyal et al.,1993) has conducted a survey on 438 credit unions by identifying on-going costs total for the 8.9 % of operating costs.
From a survey conducted on 50 operators, Franks et al. (1998) have tried to estimate the direct costs of regulation as well as those of compliance for the United Kingdom. The costs of compliance amount to 2.4 % of the operating costs (the 0.5 % is accounted for by direct payments to the authorities as fees, while 1.9 % consists of the real costs of compliance i.e. system costs, legal costs, costs for staff and costs connected with the reporting to the authorities).
Through Deloitte (2006), the FSA has examined the on-going incremental costs attributable to specific FSA rules and regulations in three areas: corporate finance, institutional fund management and investment and pension on 68 businesses (small, medium and large) operating in the three areas with different business models. The results indicated that:
§ Wholesale (corporate finance and institutional fund management) has relatively low incremental costs.
§ Corporate finance activities, linked to training and updating of human resources, absorb the largest incremental costs. In Institutional Fund Management dealing and managing (e.g best execution) absorb the highest incremental costs. In “Investment & Pension advice" highest incremental costs are due to advising and sale.
§ The retail sector, investment and pension advice has the highest incremental costs
§ There is high dispersal in incremental costs among enterprises in the same sector with regard to specific rules.
· In all areas, documentation maintenance/conservation activities presents significant cumulatively cost for the companies.
· In the retail sector, the more significant incremental costs are those related to obligations of transparency of the contractual terms and conditions (for example, in connection with the prospectuses that are provided to customers).
· In the retail sector there are no proportionately higher effects on smaller banks.
· For smaller players, the impact of regulation in the areas of corporate finance and management funds is more significant.
Among the studies by analogy there are also those conducted by Smith in 1977 aimed at assessing the costs of compliance of the Equal Credit Opportunity act in USA, and those of Baer (1988) and Hannan (1989) estimating the costs/opportunity of reserves and capital requirements. Among the most recent studies there is also that of Sathye (2008), which seeks to estimate the costs of compliance of the legislation on money laundering and the financing of terrorism for the Australian financial institutions. The results indicate that, on the whole, the cost of compliance would amount to 1.02 billion Australian dollars.
With reference to the existence of economies of scale in the activity of regulatory compliance, Murphy (1980) has used a Cobb-Douglas cost function to analyze the data collected by CBA in the first year of the Equal Credit Opportunity Act. Using two functions of cost, one for legal costs and one for the other costs of compliance and, as output, the dollar amount of consumer credit outstanding. This has resulted in identifying the existence of economies of scale: when output rises by 10% the legal costs increase by 5.7 % and the other costs by 4 %. Murphy has used the total costs, start-up and on-going as an independent variable.
Schroeder (1985) has analyzed the data collected by the Federal Reserve on start-up costs of the Electronic Fund Transfer Act, adopting as output the amount of transaction currents from customers and as other explanatory variables the dollar amount of consumer transaction currents, holding company assets, the number of offices and a variable indicating when the bank offered ATM services. Input labor prices and capital were not taken into account. Schroeder has identified economies of scale: a 10% increase in output is associated with an increase of 7.7 % of start-up costs.
Also for the on-going incremental costs the author confirms the existence of economies of scale: when there is a 10% increase of the output from electronic fund transfers the on-going costs rise by 4.3 %.
Elliehaunsen and Lowrey (2000) have analyzed the start-up costs of the Truth in Savings Act legislation and have noted the presence of such economies of scale that as the output increases (number of accounts) by 10%, the start-up costs rise by 5.6 % for small banks, 6% for medium-sized banks and 6.8 % for large ones.
Elliehaunsen and Kurtz (1988) demonstrate the existence of economies of scale for on-going costs for two regulations: Truth in Lending and Equal Credit Opportunity Act. Such economies of scale vary with the level of output (volume of accounts of consumer credit), rapidly falling as output increases. The conclusion of the study is that the economies of scale involve a competitive disadvantage for banks having smaller consumer credit portfolios but these are not so significant as to generate consolidation processes.