Abstract
The anti-money laundering (AML) provisions of the USA Patriot Act of 2001 significantly expanded the private sector's role in disrupting the financial operations of terrorist groups and criminal organizations. In doing so, the law imposed substantial compliance costs on the financial services industry as a whole. In this study, we investigate whether enforcement of the new AML measures has also caused some commercial banks and thrifts to shoulder heavier compliance-cost burdens than others. Using a dataset comprising banking institutions that hold at least one-third of their total deposits within California counties designated as ‘high-risk money laundering and related financial crime areas’, the empirical results indicate that AML compliance costs have fallen disproportionately on smaller financial institutions, suggesting that the Patriot Act has produced an intra-industry redistribution of wealth.
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References and Notes
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The California Southern District HIFCA comprises the counties of Los Angeles, Orange, Riverside, San Bernardino, San Luis Obispo, Santa Barbara and Ventura. The counties of Alameda, Contra Costa, Del Norte, Humboldt, Lake, Marin, Mendocino, Monterey, Napa, San Benito, San Francisco, San Mateo, Santa Cruz and Sonoma are under the jurisdiction of the California Northern District HIFCA.
The designations of the Southern and Northern California HIFCAs (in 2000 and 2001) coincide closely with the passage of the Patriot Act in 2001. In this respect, California represents an ideal setting for observing the effects of the post-9/11 adoption of more stringent AML compliance standards.
These variables are entered in log form as they are highly skewed.
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Others have drawn similar conclusions.22,25,30,56
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We stratified the institutions into five groups based on total assets. Small community banks and thrifts are defined as institutions with total assets amounting to less than $250 million. Midsize community banks and thrifts have total assets in the $250 million to $500 million range. Large community banks and thrifts are those with total assets between $500 million and $1 billion. Medium-to-large banks and thrifts are institutions with total assets between $1 billion and $10 billion. Lastly, the very largest commercial banks and thrifts consist of institutions with more than $10 billion in total assets. The CPI deflator was used to convert all class sizes into constant 2007 dollars.
Small community banks comprise 45.6 per cent of the observations in our dataset. In 1996 and 2007, the first and last years in our dataset, 51 per cent and 46 per cent of all US commercial banks and thrifts fell into the small community bank category, respectively.
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Note that interacting the size stratum variables with POST is equivalent to estimating two separate regression equations, one for the years before the Patriot Act and one for the years afterwards.64 (pp. 412–413) Interacting POST with MCOM, LCOM, M_L and HUGE enables one to estimate the marginal changes in those variables associated with passage of the Patriot Act.
ROA is defined as the annualized pre-tax net income as a percentage of average assets by the FDIC.49
The FDIC defines LLD as the percentage of loans and lease financing receivables net of unearned income, allowances and reserves to total deposits.49
CCR is defined as the percentage of tier 1 (core) capital to average total assets minus ineligible intangibles by the FDIC.49
The Office of Management and Budget defines metropolitan areas as including the counties surrounding central cities.49
Rose, P.S. and Hudgins, S.C. (2008) Bank Management and Financial Services. New York: McGraw-Hill.
According to the FDIC, institutions with commercial and industrial loans, real estate construction and development loans, and loans secured by commercial real estate properties, in excess of 25 per cent of total assets, are defined as specializing in commercial lending. Institutions with residential mortgage loans, plus mortgage-backed securities, in excess of 50 per cent of total assets are considered to specialize in mortgage lending.
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Elliehausen and Kurtz72 investigate scale economies in ongoing compliance with the Truth in Lending and the Equal Credit Opportunity acts. Their results indicate the existence of scale economies; however, economies of scale vary with the output level. Scale economies exist up to a certain level of output and then the average compliance cost increases slightly for the largest banks. In addition, according to Rose and Hudgins,70 a number of studies looking at cost efficiency of banking institutions examine smaller banks separately from larger banks as the array of financial products and services varies considerably between institutions of different sizes.
Unlike the coefficients on MCOM and LCOM, the coefficients on M_L in the two estimated models are statistically significant, suggesting that after the Patriot Act, the NIEAs and NIEIs of midsize-to-large banks are, on average, 34.6 per cent (=−0.2244+−0.1213) and 17.7 per cent (=−0.1131+−0.0639), respectively, lower than that of small community banks.
In our sample, the number of small community banks decreased by 183 (from 533 to 350) and their average assets increased from $115 million to $145 million from the pre-Patriot Act period to the post-Patriot Act period (class sizes are adjusted to 2007 dollars).
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The sample averages of ASSET for Bank of America and Wells Fargo Bank are $740 billion and $250 billion, respectively.
We also estimated both models using different samples that exclude observations for the largest institutions in our dataset. First, we left out observations for the top five banks with respect to total assets, as these institutions would be considered ‘outliers’ in terms of their sizes (in 2007, the last year in our dataset, the average total assets of the top five banks and the rest of the institutions in the sample were $410 billion and $2.03 billion, respectively). The signs on the coefficients of POST × MCOM, POST × LCOM and POST × M_L did not change in either of the models and the statistical significance of the coefficients was mostly unaffected. The coefficient on POST × HUGE switched from positive to negative in the first model, but it was not statistically significant. We then dropped the observations for Bank of America and Wells Fargo Bank, which are the top two largest financial institutions in our sample. There was no change in the signs on the coefficients of size stratum variables, but the statistical significance of the coefficients improved slightly.
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Dolar, B., Shughart, W. The USA Patriot Act's differential impact on large and small banks: Evidence from California's high-risk money laundering and related financial crime areas. J Bank Regul 13, 127–146 (2012). https://doi.org/10.1057/jbr.2011.22
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DOI: https://doi.org/10.1057/jbr.2011.22