Compliance Burden on Community Banks

Uncontrollable compliance costs are often cited by community banks as a reason for selling out to another institution. Is this true? While compliance costs certainly have risen continually over the past decade, we wondered if the issue had truly become critical to the long-term viability of the typical community bank.

To get a better handle on this issue, we distributed a survey earlier this year to over 300 community banks, predominately in New York or New England. Among the compliance topics probed were costs over the past three years (2009, 2010 and 2011); expected future trends in costs; where these costs are expected to grow most; how the bank expects to address compliance, whether by building its internal capacity or outsourcing; and an assessment of compliance service quality. We also inquired as to data processing and security/fraud cost trends, the quality of the service provided by these outsourced entities and prioritization of challenges over the next five years.

The survey’s 27 respondents had median total assets of $470 million, 102 employees and eight branches at year-end 2011. The middle 50% were between $256 million and $670 million in total assets, 60 to 189 employees, and 3 to 14 branches. Compliance costs, while rising modestly over the three year period, remained fairly constant as a percentage of average assets.

Good News/Bad News

These results corroborate the view that compliance costs at community banks are not particularly variable; rather, they tend to represent a more fixed cost. They also appear to be fairly modest in magnitude, as between two and five basis points is still far from the 50 to 100 basis points in after-tax return on assets that most banks generate. That was the “good” news.

The bad news is that compliance costs overall rose alarmingly between 2009 and 2011, even before all of the provisions of the Dodd-Frank Act kicked in. For the median respondent with assets of $470 million, compliance costs rose to $185,000 in 2011 from $131,000 in 2009, nearly a 19% annual increase. For the average respondent with assets of $627 million, compliance costs rose nearly 10%, to $346,000 in 2011 from $288,000 in 2009.

Looking forward, over 70% of these community banks anticipate that compliance costs will grow $50,000 per year, at least. That means annual increases of between 14% and 25%! Only 15% of respondents felt compliance costs would stabilize in the coming years.

In terms of dealing with compliance issues and the related expense, 18% of the community banks anticipate help from their state associations or joint ventures, while 26% expect to use internal resources. Over 49% believe they will use a combination of internal and other external resources (not state associations or joint ventures), whereas only 7% expect to only rely upon external service providers.

Somewhat surprising, 74% of respondents also felt that compliance costs will grow the most in the actual compliance function, not in frontline delivery of products and services. We wonder if this opinion represents just the tip of the iceberg, as we are concerned that the frontline compliance costs will mushroom in the years ahead.

Another piece of good news was that all the community banks were generally pleased with their external compliance providers, with the largest bank segment ($750 million or more) reporting extremely satisfied performance (B+ average), while both the $401 million to $750 million segment and those smallest banks with assets under $400 million surveyed were still satisfied (B average).

Based on the survey’s responses, it appears that compliance costs have yet to approach the smothering levels some pundits have led community bankers to expect. However, the expectations of future substantial increases highlighted in our survey should serve as a warning to community bankers to develop strategic plans now to mitigate the damage before these compliance expenses do get out of control. Such plans may consider initiatives such as developing stable non-interest income sources to offset future compliance costs or developing for-profit co-operative ventures with state banking associations to better manage or contain the increases.

Mr. Loomis is president of Latham, N.Y.-based Northeast Capital & Advisory, Inc. He can be reached at [email protected].