Disproportionate Costs of Uncertainty: Small Bank Hedging and Dodd-Frank

Abstract

Uncertainty in banking regulation may impose widespread economic costs by increasing financial constraints on credit availability. Four years of Dodd Frank uncertainty over undecided risk weightings increased regulatory uncertainty for smaller banks, restricting "vanilla" interest rate hedging activities. This paper uses newly reported mortgage banking data as an identification strategy and finds that when costs of uncertainty are removed, small banks hedge 97-120% more interest rate risk while mortgage securitization income increases by 65.2% compared to large banks. These findings support the need for tailored regulations that considers the higher costs of regulatory uncertainty for smaller banks.

Keywords: Costs of uncertainty, interest rate derivatives, Dodd-Frank, interest rate swaps, mortgages held for sale, interest rate locks, banking regulation, hedging, risk management, community banks

JEL Classification: G21, G28, G32