This week we are joined by Diego Zuluaga, associate director at Cato Institute’s Center for Monetary and Financial Alternatives, where he covers financial technology and consumer credit. We discuss the impact of financial regulation on community banks, the intentions vs. consequences of these regulations, and what community banks need to do stay ahead of the regulation curve in the coming years.

Diego’s work has been featured in print and broadcast media, such as the Times, Newsweek, and the Daily Telegraph. Zuluaga is a prolific public speaker as well as a former lecturer in economics at the University of Buckingham. Originally from Bilbao in northern Spain, Zuluaga holds a BA in economics and history from McGill University, and an MSc in financial economics from the University of Oxford.


Eric Bagwell: Welcome to the community bank podcast. I’m Eric Bagwell, Director of Sales and Marketing for the correspondent division at the CenterState. Bank. With me as always, is Tom Fitzgerald, Director of strategy and research in our capital markets division. Tom, how are things today?

Tom Fitzgerald: Eric, I am doing great. And I hope you are too.

Bagwell: We’re doing good. It’s pouring down rain outside. We had a fire drill this morning that we got around because of the rain. So, we’re happy that fire drills around here are not fun. They take time and they’re loud. So, 12 floors down, 12 floors back up to so before we jump into today’s show, let’s talk again about what we’ve got coming up on October the 15th. We normally have our division puts on a pretty big conference at Amelia Island every year, we’ll have probably 120 banks come down, give a lot of great information to those banks have speakers come in had to cancel that this year because of COVID. So, we say, how can we deliver some of that content anyway. And so, we came up with the idea of a live stream event. And so, we’ve got that coming up on October the 15th. Registration, links went out, or invites went out last week, we actually have folks already signed up. Tom, you want to talk a little bit about what folks can expect with that event?

Tom Fitzgerald: Sure. Eric, I think what we’re going to try to do is just kind of condense down some of that two-day session that you talked about that we do every year in an Amelia except this year, try to get the best of that talk about the economy, talk about rates, where we think that’s going to go how the election may impact all that. And then kind of follow that up with some concrete ideas as far as investment recommendations go and just again, just try to give you some actionable ideas that you can take away from and in a short amount of time, and take back to your banks and try to employ them as we try to work our way through the rest of this pandemic in 2020.

Eric Bagwell: Yeah, we’re really excited about the event on the 15th. We are hoping to have these events quarterly. This is our first one. It’ll be interactive. So please sign up, you can take part in it as well. And we want you to register. We’re sending out invites, but you can also go to our website As soon as you pull up the webpage, the invite will be right there. So, you can click on that link that comes up and register. So please do that as soon as you can. Let’s get to today’s show. Today, we’re excited to have Diego Zuluaga. He is the Associate Director at the financial regulation Studies Center for monetary and financial alternatives at the Cato Institute. And Diego, he has a wealth of knowledge when it comes to regulation. We’ve covered a lot of topics in banking, don’t think we have done a regulation topic yet. So, Diego got on with us. And for about 20 minutes or so he’s got some really good information. So, let’s go to Diego right now. Hope you enjoy the interview. Diego, we appreciate you coming on with us today.

Diego Zuluaga: Well, thank you very much for the invitation. It’s a pleasure to be with you.

Eric Bagwell: Great to have you tell us about yourself and what you do at the Cato Institute.

Diego Zuluaga: I’m an Associate Director of financial regulation studies at the Cato Institute. And Cato is a public policy research institution, better known as a think tank based in Washington DC. Now Cato focuses on all sorts of policy areas from immigration policy and foreign policy studies, all the way to economics and banking, and public health and various other areas. My focus is on financial technology and consumer credit. But in the course of that, I also look a lot at the competitive environment in banking, how banking has evolved, and how regulation affects the structure of banking and also the products that are available to American consumers. Now Cato’s goal is to promote free markets, individual liberty, and peace. The way that applies to my particular area is to identify ways in which regulatory change can increase innovation, increased competition, and improve outcomes for consumers.

Eric Bagwell: Did you make a speech earlier in the year at the New York League of independent bankers? You talked about a great movie that everyone has watched and seen. It’s a Wonderful Life. And you talk about could the Bailey brothers building and loan be a thriving independent institution today? A lot of bankers listening to this podcast have lived through a ton of changes in the banking world. But there are also some younger ones out there that maybe are even new to the industry that doesn’t know what was going on. I know Dodd-Frank seems like it added like 27,000 new restrictions. Talk a little bit about the structural changes in the US banking landscape over the years.

Diego Zuluaga: Sure. So, it’s been 75 years since it’s a wonderful life came out. And of course, the competitive landscape in US banking has changed radically during that time. First of all, we had a massive wave of consolidation and an increase in the median size of the typical, you will already have a US depository institution, the typical depository institution is much larger than it was in the past. But in addition to that, they tend to be much more likely to have branches in different states. And also, they tend to be more likely to be more active in more areas, and they were at the time that it’s a wonderful life came out, there used to be local restrictions on how many lenders that could be in a particular area, for example, and those have tended to come down since the 1970s. And particularly since the 1990s. That has increased pressure on a lot of community banks, but it’s also increased opportunities.

And what you see is that community banks, as a rule, have become much larger. And they’ve tended to the ones that have survived in that haven’t merged, have tended to, expand their operations and expand their lines of business and so on. That isn’t the only change. As you mentioned, there has been dramatic growth as well in the number of regulations to which depository institutions in any particular area of business are subject to for mortgage finance to small business lending to capital requirements to the Bank Secrecy Act, which is probably the most significant set of regulations. And that has affected their cost of doing business, their ability to compete with larger players, and in that way, may also have affected their ability to serve their communities. And so, one of the things that I focus on in my work a lot is the extent to which some well-meaning regulations actually have effects that are negative. For example, by making it more expensive to hold a bank account, you discourage people, particularly at the lower end of the income scale, from joining a bank from having a bank account from trying to develop their credit score by having access to various financial products. And that is an important negative consequence of regulation that is sometimes overlooked, and the policymakers should, in my opinion, take greater account off.

Eric Bagwell: And you even mentioned, I remember, reading something to it put out that, even with CRA, you’ve got a lot of borrowers moving into urban areas. Talk about that for a second.

Diego Zuluaga: The Community Reinvestment Act has been in place for over 40 years. And it came into force in a very different environment. At that time, many of the competitive restrictions I was talking about earlier, were still in place. And the regulations that implement the CRA have changed over time, but I don’t think they’ve changed as much as they should. And in particular, one way in which we measure performance currently, under the CRA, is to look at how much lending happens in low-income areas. That kind of mentality is a very early 1990s mentality, which is when the regulations came on, it was still a time of urban flight, there were a lot of areas, particularly low-income areas that were destitute and declining at that time.

Whereas the environment we see now, at least before the COVID pandemic was one in which more and more people were moving back into urban areas and regenerating neighborhoods. That’s all very good. But it can have the effect of displacing longtime residents that don’t have the income to keep up with rising rents and rising house prices. I think the evidence is mixed on that I think on the whole gentrification, which is what this process is known as tends to have positive effects. But one thing that I believe the CRA shouldn’t do is to give credit for mortgages that are going to higher-income residents in those areas to people who are moving in as these neighborhoods are changing, because that’s not the goal of the CRA the goal is here is to encourage low-income lending.

And therefore, I’ve pointed out that, in the DC area where I live, but also in other rapidly gentrifying metropolitan areas in coastal cities, but everywhere around the country by now that the CRA may be encouraging more lending to higher-income residents in a way that is not consistent with its mission. So as regulators review CRA regulations, which is an ongoing process, the main bank regulator just published new regulations, new final rules, the OCC did in the Fed has just begun to review its own, which itself is rare because normally they would have tried to have consistent regulations. But that’s this is a relatively new development. As they look at renewing those, they should take these strings into account and stop encouraging those kinds of activities that have nothing to do with the CRA mission.

Eric Bagwell: Diego, I want to explore a little bit more this regulation of new regulation whenever there’s a crisis and the consequences that come with that and sometimes adverse consequences. And this is really kind of near and dear to my heart. I came into the industry in the mid-80s. And I was a bank examiner, and so sort of thrown into the middle of the SNL crisis at the time and so there was a whole raft of new regular Coming from that there were all sorts of trading and investment restrictions put in place because of some of the behaviors and activities. asset-liability management got a big play in the regulations from that crisis. So, it’s been sort of an interest of mine throughout my banking career to see how new regulations Come on. And usually, they’re put input on with good intentions, there’s a desire there to correct a behavior, or to in some cases, there’s maybe a desire to punish. But generally, it’s to correct a behavior. But I know you’ve done some research and kind of looking at how regulations come about, and some of the consequences or maybe some of the adverse consequences that come about with that. So, can you talk about that for a little bit?

Diego Zuluaga: Sure. The US is special because it has a very heterogeneous banking environment, you have a lot of relatively small banks, we still have around 1300, or maybe 1200, by now depository institutions with less than 100 million in assets, which is very small. In addition to that, we have around 330 500, which are under a billion dollars in assets. Not very many countries have so many small banks. But America, of course, has very many megabanks as well. And there’s been a lot of consolidation at the top over time. For regulators that pose a challenge, because evidently not, but banks have also had different sizes can do not have the same ability to cope with regulation. And they also do not present the same systemic risk issues, Prudential risk issues, and even the same consumer protection issues, and federal regulators coming up with new rules. Try to take that into account by setting up thresholds in terms of how many units of a particular product you have to originate in order to be subject to the regulation.
This is the case with mortgages, as far as the home mortgage Disclosure Act is concerned, or what amount of assets must you have in order to be subject to this, they try to exempt the smallest institutions and the ones that are not very active in the market from regulation to try and minimize the impact. But that still means that you have a lot of depositories trying to cope with the mounting burden of different rules. And while the intention there tends to be to reduce the systemic risk that entities pose, and also to improve outcomes for consumers, you often end up in the second place, driving consumers out and driving lenders out from specific markets that are heavily regulated. But also, you may encourage concentration, you actually may encourage greater size, because the greater size makes it easier to cope with certain types of Prudential regulations. So, there’s there are a lot of unintended consequences in this type of regulatory intervention in the US market. It’s particularly challenging to cope with them because you have so many different institutions have different sizes and different specializations.

Eric Bagwell: I think we’ve certainly moved in a direction to where they’re trying to kind of categorize regulations or at least make it a little bit easier for the smaller banks. I remember in my day as you said, I would walk into a $50 million bank and basically go about the same procedures that we would have in a multibillion-dollar bank, there wasn’t a lot of distinction between them, as far as what you were asking them to do. And I think we have moved in a direction to where they are, they sort of kind of stratify some of the requirements for them now, to a degree, but I guess, I think it always will be continued to be sort of a challenge to get that mix just right of what you’re demanding of the smaller banks, versus the larger institutions.

Diego Zuluaga: I think you’re right; I think regulators are trying to take account of these issues, I don’t think it always works. For example, one thing that I’ve been pointing out for quite a while now is that the Bank Secrecy Act and the implementing regulations related to that which are all about money laundering, and financial crime, and knowing your customer. Those are very sensitive regulations because they’re related to national security issues and terrorism. And they’re policymakers on both sides of the aisle. This is not a political issue, unlike other types of financial regulation, are very concerned about this.

And therefore, enforcement is very tough, even if the regulations are not terribly transparent in their performance isn’t all that clear. But if you ask community banks, which the St. Louis Fed did a couple of years ago, about the most burdensome set of regulations that they face, they point out the BSA is at the top number one accounting for about 25% of all compliance costs. And in that particular case, even though we have financial institutions complying, very heavily filing millions of suspicious activity reports and other cash transaction reports and other kinds of filings to try and comply with this. The use of them by regulators isn’t very clear by crime enforcement agencies. That’s not clear at all. And yet, they pose a tremendous cost and even the Government Accountability Office so a government watchdog has pointed out that this particular set of very burdensome regulations are affecting how much certain groups of people living close to the border, but also immigrants, minorities, how much they can access bank accounts. So, in some areas, policymakers have still quite a lot to do in order to acknowledge that that burden that regulation may pose.

Eric Bagwell: So, to wrap it up really quick, Diego, you mentioned, you’ve got a call here in a few minutes with a senate office. And so, you do a lot of consulting with Capitol Hill, and these burdensome regulations that seem to get flooded, it’s a one size fits all, as we’ve talked about. So, a $200 million bank down in South Georgia and a huge bank up in New York City. Talk about what does the future looks like? Are we still going to have these where you kind of has to beat off the regulations? And there are comment periods? And it seems like some get passed. And three years later, it’s relieved, but what does the future look like? Are we going to continue to live in this environment where these types of regulations are pushed out? Or do you think it changes at all, at some point where every bank is not thrown into the same bucket, for a period of time?

Diego Zuluaga: I think for depositories, particularly those that are on the smaller end, it’s a challenging environment because I don’t think most of the regulations are going anywhere. But what you see is a lot of the competition coming from outside and focusing on the bits of financial services activity, that are profitable, without taking deposits, because a lot of regulation is premised on, you’re making deposits. So, you have certain firms trying to take part in the payments market, you have more and more financial technology firms coming in. And doing small business lending, which has traditionally been a community bank specialty, you have obviously a lot of activity by non-banks in the mortgage area, and you have had for a long time. And that also has to do with the fact that the government either guarantees or securitizes, the bulk of American mortgages, so it’s a very government-directed market, all of those things are going to remain in place.

And if you’re a community bank, you not only face the competition from the big guys at the top, who also have the ear of the policymaker much closer to them. But also, you have all these non-bank players that are not subject to the same regulations, often for good reason, but still not subject to the same regulations, and are competing for some of the same products you are providing. And so I think for community banks, the opportunity is to continue to do what they’ve always done best, which is relationship lending, which is identifying trades and consumers that the ordinary credit box doesn’t identify in that way, being able to lend to people that the megabanks would either not care about, or wouldn’t lend to or would lend less to.

And that has proven very successful. It’s all it’s also very good for consumers in what you see increasingly happening, as well as partnerships, partnerships with fintech partnerships with core providers that try to modernize some of the activities so that even community banks can do what some of the bigger banks have been doing for a while. And then finally, you do have acquisitions happening or mergers happening between community banks that bring that relationship lending experience, and tech players, or even, people like Google, they’ve done some partnerships with individual community banks and so on to try and help with data access data processing things that community banks are very interested in, but they may not have the scale to do. So, it is an opportunity, I think we’ve already gone through a massive wave of consolidation. So, the people who remain right now have demonstrated that they have a competitive ability that maybe others didn’t have. So, they can maybe grasp the opportunity. But the regulatory environment, I think, remains very challenging to them, and it is a major cost.

Eric Bagwell: So, what Diego’s saying is the environments not going to change regulations not going to change. Just don’t get caught flat-footed. There’s a lot of things banks can be doing. Technology-wise products you offer and you’ve just got to stay on the cutting edge of anything banking, you’ve just got to be on the cutting edge. So, keep listening to this podcast, and you’ll hear about all that stuff. So, Diego, we really appreciate you coming on with us today. I know you’ve got a very busy schedule. Thanks for taking the time and we appreciate it.

Tom Fitzgerald: Yeah, thank you, Diego.

Diego Zuluaga: I really enjoyed it. Thanks very much.


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