By Andrew Lerner
Managing Partner, IA Capital Group
I like President Obama, but despite my personal views I have to be honest: the regulations he has championed have been devastating to small businesses in financial services.
Here’s a sector-by-sector breakdown:
Small banks: Only one was created from 2011-2013
The Bank of Bird-in-Hand opened in December 2013, the first bank start-up formed in three years. Meanwhile, during those three years, about 1,000 small banks closed or merged out of existence. Regulatory requirements for new banks are now more stringent than ever, and include a seven-year period of excess capital requirements put in place in 2009. While Bird-in-Hand was forced to spend about $800,000 in start-up costs during a rigorous seven month application process, at least its application was eventually successful. Applications for banks with innovative or alternative business models never get approved. As a result, all the innovative “banking” companies you know, such PayPal or Square, are not actually banks.
Small health insurers: Legislated out of business by Obamacare
Under the Affordable Care Act health insurers are required to spend 80% of their premium dollars on medical care. That means small insurers, with relatively high overhead costs, can only use 20% of premiums to pay salaries and all other administrative expenses. This 80/20 rule was designed to help consumers, but instead it kills innovation and customer service, hallmarks of small businesses. How many stores in your hometown would exist if an expense to revenue ratio of 20% were mandated by law? Only one would survive. Welcome to the Walmartization of health insurance.
Small property/casualty insurers: They all get formed offshore
Insurance companies are regulated by the states, so one would imagine it’d be hard for the federal government to misstep in this sector. While new insurers and reinsurers sometimes go offshore to avoid state regulations, more often they simply want to avoid federal income tax. Property and casualty insurance only works if the insurer’s risks are highly diversified, so it is by necessity a global business. Perhaps more than any prior president, Obama is a strong supporter of the current US policy of taxing global corporate income, so of course no insurer doing business internationally wants to be headquartered in the US. No surprise then that the largest US trade deficit by service type is insurance, and the largest US services deficit by country is with Bermuda.
Small investment advisors: Choking on regulations
Because of onerous regulations, small investment advisors are no longer competitive. The enormous burden of complying with the registered investment advisor rules under the Dodd-Frank Act is only part of the story. More importantly, an avalanche of regulation is chasing away deep-pocketed clients like banks and foreign investors. Because of the Volcker rule, banks give almost no new business to alternative investment advisors, especially small ones. Foreign investors prefer to invest through offshore vehicles that are prohibitively expensive for small US advisors to manage. Meanwhile, US investors that invest offshore are subject to The Foreign Account Tax Compliance Act that became law in 2010. The tax reporting alone for a fund with foreign investors is an enormous burden; imagine a small business owner having to devote 267 pages of his tax return to foreign partnerships like Mitt Romney does. As a result all the money is flowing into large investment advisors with dozens of staff lawyers and compliance officers. The top 100 alternative asset managers are reporting record inflows, while small fund managers are barely staying afloat. Mutual fund companies and other traditional managers with less than several hundred million dollars in assets are universally unprofitable. There is hope, however, that new crowdfunding laws will create opportunities for small investment advisors. But President Obama doesn’t deserve outsized credit; crowdfunding was originally championed by the Republican-led House.
Tax incentives for small businesses: Financial services firms are excluded by law
The Creating Small Business Jobs Act of 2010 granted a 0% capital gains rate to small business owners who invested in their businesses through 2013. This is a huge benefit for C corporation owners, as they will owe no taxes at all (on the first $10 million of proceeds) when they sell their companies. Unfortunately, financial and professional services firms were excluded from enjoying the benefit. Prior to President Obama taking office, the maximum long-term capital gains rate was 15% for sales of all small corporations. Now, if you sell your small financial services business after five years, you pay 23.8% in federal taxes. Sell almost any other small business after five years, you pay no federal taxes.
What would you do if your firm was established to invest in small financial companies? I can tell you what we did: our firm invests mostly in financial technology companies rather than heavily regulated financial firms such as banks. And we’re not the only ones. Venture capital activity in fintech is booming, while almost no new capital is going into US financial services start-ups that are regulated. What a shame.
