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The wealth effects of the USA Patriot Act: Evidence from the
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Article  in  Journal of Money Laundering Control · August 2007

DOI: 10.1108/13685200710763470

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JMLC
10,3 The wealth effects of the USA
Patriot Act: evidence from
the banking and thrift industries
300
Burak Dolar and William F. Shughart II
Department of Economics, University of Mississippi,
Lafayette, Mississippi, USA

Abstract
Purpose – Title III of the USA Patriot Act obligated the private sector to take a more active role in
deterring money laundering and disrupting terrorist financing. Complying with the new law has
increased the cost of doing business dramatically for firms in the financial services industry. This
study aims to apply a heterogeneous-firm model of regulation to test whether the anti-money
laundering (AML) provisions of the Patriot Act redistributed wealth within the commercial banking
and thrift sectors.
Design/methodology/approach – The paper analyzes a dataset comprising more than 150,000
observations.
Findings – The empirical evidence suggests that, owing to scale economies in regulatory compliance,
the burden has fallen more heavily on smaller institutions. Moreover, the study does not find that the
rules written to implement Title III have differentially impacted banks and thrifts at greater risk of
being targeted by money launderers, as a public-interest theory of regulation would predict.
Originality/value – The paper focuses on the AML provisions of the USA Patriot Act.
Keywords United States of America, Money laundering, Legislation
Paper type Research paper

Journal of Money Laundering Control
Vol. 10 No. 3, 2007
pp. 300-317
q Emerald Group Publishing Limited
1368-5201
DOI 10.1108/13685200710763470
1. Introduction
The uniting and strengthening USA by providing appropriate tools required to
intercept and obstruct Terrorism Act of 2001, more commonly known as the USA
Patriot Act, is one of 9/11’s enduring legacies. At 125 pages, Title III is the most
extensive of the Patriot Act’s provisions. Under this title, private businesses, mostly in
the financial services industry, are required to take a more active role in deterring
money laundering and disrupting the flow of funds to terrorist networks.
Money laundering, which can be defined as the process of concealing the existence,
source, and usage of income acquired from criminal activities, is an essential
complement to almost all profit-generating illegal activities (United Nations
International Drug Control Program, 1997). According to International Money Fund
(IMF) estimates, cash and other liquid capital representing between 2 and 5 percent of
world gross domestic product (GDP) is laundered every year, percentages that
translate into US $600 billion to 1,500 billion (USA Patriot Act, Title III, § 302).
This paper is based on the first-named author’s doctoral dissertation (Dolar, 2007). The authors
benefited from comments by Hui-chen Wang, Michael Belongia, Simona Lup Tick, and Krishna
Ladha as well as committee members Mark Van Boening, Jon Moen and Milorad Novicevic, all of
whom added considerable value to the paper. As is customary, however, the authors accept full
responsibility for any remaining errors.
Charles (2004) claims that half of money laundering activity worldwide takes place The wealth
within the US financial system as a whole, with 47 percent of the global total laundered effects of the
through US commercial banks.
Title III of the Patriot Act imposes stringent anti-money laundering (AML) USA Patriot Act
regulations on a wide range of financial institutions. The new rules require developing
written AML procedures; establishing enhanced due diligence policies to identify and
verify clients; implementing stricter recordkeeping and reporting measures; 301
cross-checking the names on accounts with various government lists of individuals
and organizations known or suspected of being involved in money laundering and
terrorism; appointing officers to administer AML compliance programs and provide
guidance to other employees; designing an ongoing employee training program;
conducting independent audits to test the effectiveness of AML policies; and involving
top management in the process. Title III not only affects institutions based in the USA;
owing to the US financial sector’s global significance, the new AML rules impact
financial institutions worldwide to greater or lesser degrees.
The existence of scale economies in complying with banking regulations compliance
is fairly well-established (Schroeder, 1985; Elliehausen, 1998; Newman, 2003). Viewed
from the perspective of a heterogeneous-firm model of regulation, economies of scale in
regulatory compliance supply incentives for larger, more efficient institutions to seek
competitive advantages over their smaller, less efficient competitors by lobbying for
rules that increase the cost of doing business industry-wide. Given that the interests of
larger, lower-cost and better-politically-organized institutions tend to dominate the
interests of smaller, higher cost and less-well-organized institutions in the regulatory
process, the effects of regulation get distributed asymmetrically within the industry.
Even though there is no evidence that large banks explicitly pushed for favorable
treatment when the regulations enforcing Title III were being written, a subset of
banks have made efforts to impose uniform AML standards on the entire industry
(Small, 1999). In addition, there is reason to believe that regulatory agencies based their
“know your customer” (KYC) policy requirements on the practices and experiences of
large financial institutions (Biern, 1998).
Employing a large dataset containing more than 150,000 observations on US
commercial banks, savings and loan associations, and savings banks (the latter two are
also called “thrifts”), we test whether or not the AML provisions of the Patriot Act led
to a transfer of wealth from small institutions to large institutions. We also test
competing hypotheses derived from a public-interest theory of regulation, which would
predict that banking regulators followed a risk-based approach in writing,
administering, and enforcing the new AML rules, thereby focusing their time and
effort on the financial institutions most likely to be targeted by money launderers. In
order to do so, we examine the impact of the Patriot Act on compliance costs across
institutions differing as to their business specializations, market characteristics,
proximity to national borders, involvement in interstate banking operations, and
affiliation with a multibank holding company.
To test these private-interest and public-interest hypotheses, we specify and
estimate an empirical model designed to explain cross-sectional and time-wise
variations in total non-interest expenditures (TEXP), our proxy for institutional
compliance costs. The results of estimation indicate that, other things being the same,
an increase in institution size causes a less than proportional increase in TEXP.
JMLC This finding suggests that small institutions have borne a disproportionately higher
10,3 compliance burden than large institutions. Complying with the AML provisions of the
Patriot Act redistributed wealth asymmetrically, benefiting large commercial banks
and thrifts at the expense of their smaller competitors. Moreover, we do not find that
banking regulators have followed a risk-based approach in designing and enforcing
the new AML controls, lending additional support to the heterogeneous-firm model of
302 regulation.

2. The intra-industry wealth redistribution effects of regulation

In the simplified version of the “capture theory” of regulation (Stigler, 1971), a unified
group of producers maximizes the wellbeing of its members at the expense of politically
unorganized consumers. On the other hand, in Peltzman’s (1976) more general theory of
regulation, regulators balance the interests of producers and consumers so that neither
group gains all of the benefits of regulatory intervention, except when one of them is
politically impotent and the model reduces to one of Stiglerian capture.
Other students of economic and social regulation recognized, however, that the
firms within an industry often have competing interests with respect to the outcomes
of regulatory processes. The heterogeneous-firm model of regulation suggests that
imposing the same regulatory standards on all of an industry’s members can make the
more efficient firms better off. Buchanan and Tullock (1975) were the first economists
to construct such a theory of regulation (Tollison, 1991).
Existing evidence supporting the heterogeneous-firm model of regulation is limited
and eclectic. In his paper on wage rates as a barrier to entry, Williamson (1968)
explores the intra-industry effects of collective bargaining agreements that require all
of an industry’s members to adopt the same pay scale. He argues that, by causing total
wage bills to increase asymmetrically, industry-wide wage agreements benefit
capital-intensive firms at the expense of rivals employing more labor-intensive
production methods. As a result of disproportionate increases in labor costs, some of
the industry’s smaller firms are forced to exit and small-scale entry is discouraged,
thus enhancing the wealth of the firms that rely less on labor inputs.
Marvel (1977) presents an analysis of the nineteenth-century British Factory Acts.
Despite the conventional wisdom that Lord Althorp’s 1833 bill was intended to
protect vulnerable workers from exploitation by greedy textile manufacturers, Marvel
argues that the law, which limited the labor supply of women and children, had the
effect of enhancing (and, thus, was designed to enhance) the wealth of a subset of the
firms as well as that of male operatives. Observing that the marginal productivity of
labor differed between steam-powered and water-powered mills, he concludes that the
legislation differentially burdened the owners of firms using the older technology.
Specifically, the Factory Acts gave steam-powered mills a significant cost advantage
over their water-powered competitors, which could not operate year-round and which
relied more heavily on young female workers and children as a source of labor at times
when sufficient water power was available.
According to Maloney and McCormick (1982), environmental quality regulations
often produce winners and losers within an industry. If firms in the industry have
different cost structures, a cost-increasing regulation is likely to raise the market value
of the low-cost firms and decrease the value of the high-cost firms. That is because, as
Maloney and McCormick (1982, p. 105) state:
 . . .if the most efficient firms in the industry can comply most cheaply with the law, then the The wealth
industry supply curve will shift upward and become more inelastic; market price will increase
more than costs for some firms. The rents of marginal firms will decline and some will exit as effects of the
they face higher costs. USA Patriot Act
Bartel and Thomas (1987) divide the wealth effects of regulation into two categories.
The direct effects of regulation increase manufacturing costs for the entire industry. On
the other hand, the indirect effects of regulation apportion competitive advantages 303
unequally because of the asymmetrical (or heterogeneous) distribution of regulatory
compliance costs among the industry’s members. For example, if the cost of complying
with a regulation is higher for one group of firms than another, the regulation gives a
competitive edge to the latter group. Indeed, Bartel and Thomas argue that regulation
may actually yield net benefits for the low-compliance-cost group, if the positive
indirect effects more than offset the negative direct effects.
Ekelund et al. (1995) analyze the wealth distribution effects of the Clayton Act of
1914. They stress the existence of competing special interest groups that gained
and lost from the passage of that antitrust law. According to the authors, the
Clayton Act transferred wealth from expanding firms to established, more slowly
growing firms. In addition, businesses operating solely within the boundaries of
one state gained protectionist benefits at the expense of “foreign” (out-of-state)
firms attempting to enter their markets. The Clayton Act mediated this wealth
transfer by strengthening the antitrust authorities’ powers to condemn horizontal
and vertical restraints of trade, thereby making it more difficult for firms not
already operating in more than one state to expand and compete more effectively
in broader geographic markets.
Studies conducted in yet other industries and regulatory contexts yield similar
conclusions[1]. When firms differ in terms of their costs of complying with regulatory
mandates, one-size-fits-all regulation evidently can produce significant intra-industry
redistributions of wealth.
The industrial organization of the commercial banking and thrift sectors fits the
assumptions of the heterogeneous-firm model of regulation and of the interest-group
theory of government more generally (McCormick and Tollison, 1981). Large banks
comprise a relatively small, homogeneous group with significant financial stakes in the
writing and implementation of banking regulations, including the Patriot Act’s AML
provisions. On the other hand, small banks represent a relatively large, heterogeneous
group having more diffuse interests in the regulatory process. In addition, consistent
with the logic of collective action (Olson, 1965), large financial institutions have more
resources to lobby for favorable regulatory treatment and are able to control
free-riding more effectively than small institutions. Accordingly, large banks have the
characteristics of demanders of wealth transfers, whereas small banks have
the characteristics of suppliers of wealth. Given scale economies in regulatory
compliance, the heterogeneous-firm model accordingly predicts that large banks and
thrifts benefited from Title III of the Patriot Act at the expense of the financial sector’s
smaller members.

3. Economies of scale in regulatory compliance

Banking regulations impose substantial administrative and financial burdens on the
industry as a whole. Billions of dollars are spent every year to comply with these
JMLC regulations (Elliehausen, 1998). Our heterogeneous-firm model of Title III of the Patriot
10,3 Act hinges on the existence of intra-industry differences in the cost of complying with
the law’s AML provisions. This section summarizes the limited literature addressing
the extent to which complying with bank regulations is subject to economies of scale.
All of the available evidence suggests the existence of substantial scale economies in
regulatory compliance, which includes both start-up and ongoing compliance costs.
304 Although a particular financial regulation increases costs industry-wide, given
scale economies in regulatory compliance, larger institutions would gain an advantage
over their smaller competitors because the negative effects of a cost-increasing
regulation loom larger for high-cost institutions than for low-cost institutions. Simply
put, scale economies in complying with banking regulations mean that smaller banks
experience higher average costs of compliance than their larger rivals, supplying the
latter with an important competitive edge (Elliehausen, 1998). More specifically:
. . .small institutions experience a cost disadvantage in compliance because small institutions
incur many of the same costs as large institutions do in setting up and maintaining their
compliance programs, and therefore they must devote a larger proportion of their resources to
compliance (Schroeder, 1985, p. 4).
In addition, “regulatory costs might inhibit the entry of new firms into banking or
might stimulate consolidation of the industry into fewer, larger banks” (Elliehausen,
1998, p. 25).
Complying with the new AML measures of the Patriot Act has been far more costly
than was the case with earlier regulatory attempts to curb money laundering, which
focused primarily on the proceeds of drug trafficking. Since, 2001, the cost of doing
business has increased dramatically for banks as well as other institutions in the
financial services industry. Roberts (2004, p. 592), for instance, reports that, “banks,
brokerage firms, and other financial institutions spent over $11 billion in 2002 to
strengthen their internal AML controls”[2].
Smaller financial institutions face several disadvantages in complying with Title III
of the Patriot Act. It has been estimated, for instance, that compliance costs absorb as
much as 20 percent of the profits of small institutions, on the average (Economist,
2003). Unlike many small and midsize institutions, large institutions possess the
resources and organizational ability to implement the Patriot Act’s new AML
regulations. It is also true that most large institutions already had comprehensive
AML programs in place before the Patriot Act; they were consequently better
positioned to comply with the revised regulations.
The Patriot Act also has contributed to the trend, already well underway, towards
consolidation of the banking industry through mergers and acquisitions. The fixed
investment required to cope with regulatory mandates, both old and new, is very high
for most small institutions, which operate only a few branches. In contrast, large
institutions are able to spread their compliance costs over a more extensive customer
base and, hence, experience lower average total costs than their smaller competitors
(Newman, 2003).

4. Empirical model and results

This section describes our dataset, presents the specification of our empirical model,
including a priori expectations, and reports the results of testing private-interest and
public-interest theories of the Patriot Act’s AML provisions. It is important to The wealth
emphasize in this regard that the language of the new law could not have been effects of the
anticipated. Under the threat of possible further terrorist attacks after 9/11, the 107th
Congress had approximately one month to review and make necessary changes to the USA Patriot Act
bill introduced by the Bush administration. The act was approved by the House and
the Senate without much debate. As such, it is reasonable to conclude that the
compliance activities of financial institutions were not influenced by expectations of 305
regulatory change prior to October 26, 2001, the date on which the Patriot Act was
signed into law by President Bush.

4.1 Description of the dataset

The data analyzed below come from the Federal Deposit Insurance Corporation’s
(FDIC) database, which contains demographic and financial information on all
FDIC-insured US commercial banks and thrifts. The annual observations cover the
period from 1992, when the FDIC’s dataset begins, to 2005, inclusively, and they
encompass the entire population of these institutions during the sample period.
Comparing the time before (i.e. years 1992 through 2001) and after (i.e. years 2002
through 2005) the passage of the Patriot Act enables us to test whether the new AML
procedures differentially impacted individual US commercial banks and thrifts.
The dataset used in the empirical work has both cross-sectional and time-series
dimensions since it pools observations on individual institutions over 14 years.
However, the data do not represent a true panel dataset because the same
cross-sectional units (i.e. commercial banks and thrifts) cannot be followed over the
entire 14-year period. Observations are missing throughout the study period for many
commercial banks and thrifts owing to the rapid transformation of the industry
through mergers and acquisitions, closings from failures, and new bank formations,
leaving a total of 150,722 observations for analysis. Table I shows the number of
observations in the dataset by size stratum and year[3].

Large banks Midsize banks Large-community Small-community Total

Year and thrifts and thrifts banks and thrifts banks and thrifts by year

1992 94 659 615 12,567 13,935

1993 102 606 580 11,997 13,285
1994 112 587 546 11,362 12,607
1995 114 577 543 10,738 11,972
1996 113 541 551 10,249 11,454
1997 100 526 506 9,791 10,923
1998 103 503 512 9,346 10,464
1999 109 497 509 9,107 10,222
2000 113 480 508 8,803 9,904
2001 106 480 544 8,484 9,614
2002 117 474 574 8,189 9,354
2003 117 487 564 8,013 9,181
2004 121 497 576 7,781 8,975 Table I.
2005 118 512 616 7,586 8,832 Number of observations
Total by by size stratum,
stratum 1,539 7,426 7,744 134,013 150,722 1992-2005
JMLC 4.2 Model specifications
10,3 We use pooled ordinary least squares (OLS) analysis to estimate a cost function
designed to assess the before-and-after effects of institution size on TEXP, which, as
discussed more fully below, is our proxy for the costs incurred in complying with
Title III of the Patriot Act. The cost relationship is specified as linear in the natural
logarithms of all continuous variables; the estimated coefficients on these variables can
306 therefore be interpreted as elasticities. All dollar amounts were converted to constant
2005 dollars using the consumer price index (CPI) deflator.
The regression model has the following form[4].

TEXP ¼ b0 þ b1 POST þ b2 ASSET þ b3 POST £ ASSET þ b4 LARGE £ ASSET

þ b5 POST £ LARGE £ ASSET þ b6 MIDSIZE £ ASSET
þ b7 POST £ MIDSIZE £ ASSET þ b8 LCOMM £ ASSET
þ b9 POST £ LCOMM £ ASSET þ b10 COM þ b11 POST £ COM þ b12 AGR
þ b13 POST £ AGR þ b14 BANK þ b15 POST £ BANK þ b16 NBOR
þ b17 POST £ NBOR þ b18 SBOR þ b19 POST £ SBOR þ b20 METRO
þ b21 POST £ METRO þ b22 INTOFF þ b23 POST £ INTOFF þ b24 MHOLD
þ b25 POST £ MHOLD þ b26 ROA þ e:

Descriptive statistics for all of the variables are shown in Table II.

4.3 Description of variables and a priori expectations

4.3.1 Dependent variable: total non-interest expenditures (TEXP). TEXP serves as
proxy for regulatory compliance costs and enables us to observe the distribution of the
Title III compliance burden across a heterogeneous sample of commercial banking and
thrift institutions. TEXP include many budgetary line items, such as managerial
and employee compensation, premises and equipment expenses, training expenses,
professional and outside services, travel and conference expenses, supply expenses,

Variable Mean Standard deviation Minimum Maximum

TEXP 2.08 £ 107 2.94 £ 108 2 1.41 £ 108 2.98 £ 1010

POST 0.2411 0.4278 0 1
ASSET 7.55 £ 108 1.03 £ 1010 1,216.82 1.08 £ 1012
LARGE 0.0102 0.1005 0 1
MIDSIZE 0.0493 0.2164 0 1
LCOMM 0.0514 0.2208 0 1
COM 0.3498 0.4769 0 1
AGR 0.2094 0.4069 0 1
BANK 0.8363 0.3700 0 1
NBOR 0.1335 0.3401 0 1
SBOR 0.1595 0.3661 0 1
METRO 0.4960 0.5000 0 1
INTOFF 0.0295 0.1692 0 1
Table II. MHOLD 0.2469 0.4312 0 1
Descriptive statistics ROA 1.0249 2.6128 2 86.84 236.72
and overhead expenses. This dependent variable has been used widely in studies of The wealth
compliance issues in the financial services industry[5]. effects of the
Following the Patriot Act’s passage, banking institutions had to hire new employees
or reassign current employees to fill compliance officer positions. Owing to the cost of USA Patriot Act
implementing the new rules, banks and thrifts started using people in non-supervisory
jobs to carry out routine compliance activities, such as performing AML checks and
preparing reports. Fulfilling Title III’s AML mandates also increased managerial 307
expenses for coordinating compliance activities, monitoring employee compliance,
reviewing procedures, and designing auditing programs.
Complying with the new AML measures of the Patriot Act has required institutions
to invest in expensive hardware and software technologies. In addition, existing
information systems had to be modified and client records updated. Institutions had to
establish extensive training programs to educate employees from various departments
about the changes in AML procedures. Outsourcing consulting, legal and other
professional assistance with compliance issues constituted a major expense item for
institutions in the banking industry. In addition, officers and employees were required
to participate in several conferences on the new AML regulations. For these reasons
and more, TEXP of commercial banks and thrifts are expected to have increased after
the Patriot Act became law, as others have concluded (Fisher et al., 2005; Economist,
2005).
4.3.2 POST. POST takes a value of 1 for observations from the years 2002 to 2005,
inclusively, and a value of 0 for observations from the pre-Patriot Act years, 1992
through 2001. The estimated coefficient on POST is expected to be greater than zero,
assuming that, other things being the same, complying with its AML provisions
caused the TEXP of institutions in the banking industry to increase. Interacting POST
with other explanatory variables enables one to estimate the marginal change in the
corresponding variable associated with the passage of the Patriot Act.
4.3.3 ASSET. ASSET, the total assets of an institution, serves as proxy for
institution size. The coefficient on ASSET measures the elasticity of TEXP with
respect to firm size. Although one would expect to observe a positive relationship
between an institution’s total assets and its TEXP under alternative hypotheses, our
test of the heterogeneous-firm model of regulation focuses on the magnitude of the
estimated coefficient on ASSET[6]. A coefficient greater than unity means that a
1 percent increase in total assets leads to a more than 1 percent increase in TEXP,
ceteris paribus. A coefficient that is smaller than unity has the opposite interpretation.
Estimating the elasticity of TEXP with respect to firm size enables us to test
whether or not the AML provisions of the Patriot Act redistributed wealth within the
banking industry. If the coefficient on ASSET is found to be significantly smaller in
the post-Patriot Act period than in the pre-Patriot Act period, that result would support
the hypothesis that small institutions have borne disproportionately higher compliance
costs than large institutions.
4.3.4 Size stratum variables. The dummy variables LARGE, MIDSIZE, and
LCOMM, the last of which denotes large community banks, take the value of 1 when
the observed institution falls into the appropriate size category and 0 otherwise.
Interacting these size stratum variables with ASSET facilitates a more direct test of the
wealth-transfer hypothesis. The coefficient on LARGE £ ASSET, for example,
indicates the pre-Patriot Act difference in the elasticity of TEXP with respect to
JMLC institution size between the largest commercial banks and thrifts, and the omitted base
10,3 group (which we define as small community banks and thrifts). Similarly, the
coefficient on POST £ LARGE £ ASSET indicates the elasticity of TEXP with
respect to institution size between the largest institutions and the base group following
the Patriot Act’s passage. As such, a coefficient on POST £ LARGE £ ASSET that is
significantly smaller than the coefficient on LARGE £ ASSET would lend support to
308 the hypothesis that the Patriot Act has imposed a disproportionately lower
compliance burden on larger institutions. Similar reasoning applies to comparisons
between MIDSIZE £ ASSET and POST £ MIDSIZE £ ASSET and between
LCOMM £ ASSET and POST £ LCOMM £ ASSET.
4.3.5 Business specialization variables. The variables COM, indicating commercial
client specialization, and AGR, indicating agricultural client specialization, enable us to
test whether or not business specialization has had any impact on the intra-industry
distribution of Title III compliance costs. These two dummy variables take the value of
1 when the business specialization of the observed institution falls into the appropriate
category. The FDIC defines commercial institutions as ones engaging in commercial
and industrial loans, real estate construction and development loans, and loans secured
by commercial real estate properties, in excess of 25 percent of total assets.
Agricultural commercial banks and thrifts are defined as institutions with agricultural
production loans plus real estate loans secured by farmland, in excess of 25 percent of
total loans and leases[7]. The omitted base group comprises institutions with other
specializations.
The public-interest theory would suggest that institutions specializing in
transactions carrying greater money laundering risk face more regulatory scrutiny
and, hence, bear higher costs of complying with the Patriot Act’s AML provisions than
institutions that are not targeted by money launderers. The estimated coefficients on
COM and AGR will provide evidence on differential compliance cost burdens, if any,
across institutions with these two primary business specializations. One would suspect
that banks and thrifts having relationships with commercial clients are more likely to
be involved in transactions at greater risk for money laundering than those with closer
ties to the agricultural sector, but we will let the data speak.
4.3.6 BANK. This dummy variable takes the value of 1 when the observed
institution is a commercial bank and 0 if it is a thrift. BANK is entered as an
explanatory variable in order to test whether the compliance burden differs between
these two types of financial institutions. If one conjectures that drug traffickers and
terrorists are more likely to attempt to launder money through commercial banks than
through thrifts, and that commercial banks are therefore subject to more stringent
AML regulations, then a positive coefficient on COM would be consistent with a
public-interest, risk-based approach to Title III enforcement. On the other hand, it may
turn out that the cost of complying with Title III does not differ by institution type.
We will see.
4.3.7 Border state variables. NBOR takes the value of 1 when the headquarters of the
observed institution is located in Washington, Idaho, Montana, North Dakota,
Minnesota, Michigan, New York, Vermont, New Hampshire, Maine, or Alaska. SBOR
takes the value of 1 when the headquarters of the observed institution is located in
California, Arizona, New Mexico, Texas, or Florida. The base group includes
institutions headquartered elsewhere. A public-interest theory of AML regulation
would suggest that institutions located close to national borders and foreign markets The wealth
face higher compliance costs than the ones which are not, on the assumption that effects of the
geographical proximity increases the risk of involvement in money laundering
transactions. USA Patriot Act
4.3.8 METRO. Similar reasoning applies to METRO, which takes the value of 1
when the headquarters of the observed institution is located in a metropolitan area and
0 otherwise[8]. On the assumption that big-city banks and thrifts are more likely to be 309
targeted by money launderers than institutions located in less densely populated areas,
a public-interest theory would predict that the former have been required to spend
more of their resources on AML compliance than the latter. The estimated coefficient
on METRO will supply evidence on this issue.
4.3.9 INTOFF. The dummy variable INTOFF takes the value of 1 when the
observed institution has offices in at least two different states; it is set equal to 0
otherwise. The burden of complying with the Patriot Act’s AML provisions plausibly
falls more heavily on banks and thrifts operating in different geographical markets and
different state regulatory jurisdictions than on those whose operations are confined to a
single state. Holding other things constant, including institution size and the
corresponding ability to exploit economies of scale in regulatory compliance, the
estimated coefficient on INTOFF will tell us whether the intra-industry distribution of
compliance costs varies with respect to the geographical diversity of financial
institutions’ operations.
4.3.10 MHOLD. Elliehausen and Lowrey (1997) test the hypothesis that institutions
owned by multibank holding companies are able to share compliance resources among
their affiliates and, hence, have lower average compliance costs than institutions
owned by one-bank holding companies and independent banks (i.e. banks that do not
have a bank holding company affiliation). They report evidence supporting that
hypothesis. We include MHOLD, which takes a value of 1 when the observed
institution is owned by a multibank holding company and 0 otherwise, to test whether
the same relationship can be found with respect to compliance with Title III of the
Patriot Act.
4.3.11 ROA. Return on assets (ROA) controls for institution-specific financial
performance. The estimated coefficient on ROA would be expected to be less than zero,
assuming that financially strong institutions have lower TEXP than financially weak
ones, ceteris paribus.

4.4 Results
OLS regression analysis generates the results reported in Table III. The estimated
regression model is statistically significant at the 1 percent level and explains more
than 90 percent of the variation in total institutional non-interest expenditures, which is
our proxy for regulatory compliance costs. Of the 26 parameter estimates included in
the model, 24 are significant at the 1 percent level and two are significant at the
5 percent level.
POST, the dummy variable for observations from the post-Patriot Act years, has the
expected positive sign. It indicates that US financial institutions, on the average,
incurred 44.7 percent higher TEXP in the post-Patriot Act period than in the
pre-Patriot Act period.
JMLC
Variable Coefficient t-statistic p-value
10,3
Intercept 2 1.5032 253.07 , 0.001
POST 0.4470 7.70 , 0.001
ASSET 0.8738 569.10 , 0.001
POST £ ASSET 2 0.0165 25.23 , 0.001
310 LARGE £ ASSET 0.0244 36.61 , 0.001
POST £ LARGE £ ASSET 2 0.0042 23.39 0.001
MIDSIZE £ ASSET 0.0113 31.62 , 0.001
POST £ MIDSIZE £ ASSET 2 0.0034 24.86 , 0.001
LCOMM £ ASSET 0.0059 17.92 , 0.001
POST £ LCOMM £ ASSET 2 0.0020 23.28 0.001
COM 0.0607 19.56 , 0.001
POST £ COM 2 0.0139 22.20 0.028
AGR 2 0.1709 246.79 , 0.001
POST £ AGR 0.0156 1.98 0.048
BANK 0.2349 62.43 , 0.001
POST £ BANK 2 0.1317 216.85 , 0.001
NBOR 0.0633 16.89 , 0.001
POST £ NBOR 2 0.0408 25.44 , 0.001
SBOR 0.1592 45.10 , 0.001
POST £ SBOR 2 0.0797 210.99 , 0.001
METRO 0.1472 50.17 , 0.001
POST £ METRO 2 0.0663 211.24 , 0.001
INTOFF 0.1276 13.80 , 0.001
Table III. POST £ INTOFF 0.0803 5.67 , 0.001
Regression results: MHOLD 2 0.0188 26.27 , 0.001
distribution of total POST £ MHOLD 2 0.0451 27.09 , 0.001
non-interest expenditures ROA 0.0155 37.06 , 0.001
in the banking industry Adjusted R 2 0.9033
before and after the F-statistic 54152.97
Patriot Act p-value , 0.001

The coefficient on ASSET, which measures the elasticity of TEXP with respect to
institutional size, is less than unity and statistically significant at the 1 percent level.
The result indicates that in the pre-Patriot Act period, a 10 percent increase in total
assets size resulted in an 8.7 percent increase in TEXP, ceteris paribus. When interacted
with POST, the estimated coefficient is negative and is significant at the 1 percent
level. The negative sign on POST £ ASSET implies that the elasticity of TEXP with
respect to total assets is lower in the post-Patriot Act period, ceteris paribus, with each
10 percent increase in institution size resulting in an 8.573 percent ( ¼ 0.8738 2 0.0165)
increase in TEXP (Table IV)[9]. This result supports the hypothesis derived from the
heterogeneous-firm model of regulation that the cost of complying with Title III of the
Patriot Act has fallen more heavily on small institutions than large institutions.
Turning to the coefficient on LARGE £ ASSET, our results indicate that before
the Patriot Act, TEXP tended to be more elastic with respect to total assets for large
commercial banks and thrifts than for small community banks and thrifts. After the
Patriot Act, the elasticity has continued to be greater for the former group; however,
the difference is smaller, as indicated by the negative coefficient of
POST £ LARGE £ ASSET. For the period before the Patriot Act, a 10 percent
 The wealth
Coefficient before the Coefficient after the Pre- and post-Patriot
Variable Patriot Act Patriot Act Act difference effects of the
POST – 0.4470 0.4470
USA Patriot Act
ASSET 0.8738 0.8573 2 0.0165
LARGE £ ASSET 0.0244 0.0202 2 0.0042
MIDSIZE £ ASSET 0.0113 0.0079 2 0.0034 311
LCOMM £ ASSET 0.0059 0.0039 2 0.0020
COM 0.0607 0.0468 2 0.0139
AGR 2 0.1709 20.1553 0.0156
BANK 0.2349 0.1032 2 0.1317
NBOR 0.0633 0.0225 2 0.0408
SBOR 0.1592 0.0795 2 0.0797
METRO 0.1472 0.0809 2 0.0663
INTOFF 0.1276 0.2079 0.0803 Table IV.
MHOLD 2 0.0188 20.0639 2 0.0451 Estimated coefficients on
explanatory variables
Note: The difference between the pre- and post-Patriot Act coefficients is significant at the before and after the
1 percent level, on a one-tailed test, for all variables Patriot Act

increase in institution size resulted in a 0.24 percent (the coefficient on LARGE) greater
increase in TEXP for large institutions than for small community banks and thrifts.
For the period after the Patriot Act, a 10 percent increase in institutions size resulted in
a 0.202 percent ( ¼ 0.0244 2 0.0042) greater increase in TEXP for large institutions
than for small community banks and thrifts. The coefficients on the other size stratum
variables indicate that the same relationship exists between midsize institutions and
small community banks and thrifts, and between large community banks and thrifts
and small community banks and thrifts. These results are consistent with the
wealth-transfer hypothesis that the compliance costs of larger institutions have
increased less than proportionally with firm size after the Patriot Act.
The results suggest that, in terms of compliance costs, commercial banks are better
off and agricultural banks are worse after the Patriot Act. Before the new AML law,
institutions specializing in commercial banking had 6.07 percent higher TEXP than
institutions with other specializations, while institutions specializing in agricultural
banking incurred 17.09 percent lower TEXP than institutions with other
specializations, ceteris paribus, as indicated by the estimated coefficients on COM
and AGR, respectively. The coefficient on POST £ COM indicates that for the period
after the Patriot Act, institutions specializing in commercial banking, on average, have
experienced just 4.68 percent ( ¼ 0.0607 2 0.0139) higher TEXP than institutions
included in the base group. The coefficient on POST £ AGR, on the other hand,
implies that in the post-Patriot Act era, institutions specializing in agricultural
banking, on average, have experienced 15.53 percent ( ¼ 2 17.09 þ 0.0156) lower
TEXP than institutions included in the base group.
Commercial banks seem to have been made better off by the Patriot Act than thrift
institutions. The coefficient on the institution variable, BANK, indicates that for the
period before the Patriot Act, a commercial bank, on average, incurred 23.49 percent
higher TEXP than a thrift, ceteris paribus. For the period after the Patriot Act, the
difference in TEXP between a commercial bank and a thrift dropped by 13.17 percent
JMLC (the coefficient on POST £ BANK), indicating that thrifts have been affected more
10,3 adversely by the new AML measures than commercial banks, ceteris paribus.
The findings indicate that in the pre-Patriot Act period, institutions headquartered
in one of the Northern Border States, on average, incurred 6.33 percent higher TEXP
than institutions that are not located in one of the Border States, ceteris paribus. In the
post-Patriot Act period, the difference in TEXP between the two groups dropped to
312 2.25 percent ( ¼ 0.0633 2 0.0408). Similarly, the coefficient on SBOR implies that in the
pre-Patriot Act period, institutions located in one of the Southern Border States, on
average, incurred 15.92 percent higher TEXP than institutions that are not located in
one of the Border States and the difference between these groups has become
7.95 percent ( ¼ 0.1592 2 0.0797) in the post-Patriot Act period. The coefficient on
METRO implies that before the Patriot Act, institutions operating in metropolitan
areas, on average, had 14.72 percent higher TEXP than institutions operating outside
metropolitan areas, ceteris paribus. The difference in TEXP between the two groups
decreased by 6.63 percent (the coefficient on POST £ METRO) after the Patriot Act.
In addition, the results in Table III suggest that before the Patriot Act, institutions with
interstate branches, on average, had 12.76 percent (the coefficient on INTOFF) higher
TEXP than those without interstate branches and after the Patriot Act, the TEXP of
the former, on average, have been 20.79 percent ( ¼ 0.1276 þ 0.0803) higher than the
latter.
The post-Patriot Act coefficients on the variables COM, AGR, BANK, NBOR, SBOR,
and METRO do not lend support to a public-interest, risk-based approach to
regulation. If so, institutions that are more vulnerable targets for money launderers and
that are more likely to be involved in money laundering transactions would have borne
a greater compliance burden than institutions that pose a lower money laundering risk.
Interestingly, the results suggest that, gauged in terms of their TEXP, commercial
banks, institutions which specialize in commercial clients and which are located close
to borders and foreign markets, and big-city banks and thrifts are better off after
the Patriot Act. The coefficient on POST £ INTOFF, however, is consistent with the
hypothesis that institutions operating branches in more than one state, hence,
managing more diverse banking activities (both geographically and jurisdictionally)
have incurred higher compliance costs than banks and thrifts operating solely within
the borders of a single state.
The estimated regression indicates that in the pre-Patriot Act period, institutions
owned by multibank holding companies, on average, incurred 1.88 percent lower total
non-interest expenditures than institutions which are not affiliated with a multibank
holding company, ceteris paribus. The difference in TEXP between the two groups
increased to 6.39 percent ( ¼ 2 0.0188 2 0.0451) in the post-Patriot Act period. This
result shows that institutions owned by multibank holding companies may indeed be
able to share some compliance activities among affiliated institutions.
Finally, our a priori expectations were not fulfilled for the variable ROA. The
estimated coefficient indicates that a one unit increase in an institution’s ROA – which
is a substantial change in that measure of financial performance – causes a 1.55 percent
increase in TEXP, ceteris paribus. Financially strong banks and thrifts were hit harder
by the requirements of Title III than the weaker members of their industry. On the
other hand, the magnitude of the coefficient is relatively small and so this result may
have little economic significance.
 We estimated alternative specifications of our model including control variables The wealth
indicating: effects of the
.
each financial institution’s primary regulatory agency (i.e. the FDIC, the Board of USA Patriot Act
Governors of the Federal Reserve System, the Office of the Comptroller of the
Currency, or the Office of Thrift Supervision); and
.
whether the institution holds a federal or state charter.
313
Including these additional variables did not affect the signs or statistical significance of
the estimated coefficients reported in Table III[10].

5. Concluding remarks
The AML provisions of the Patriot Act were intended to disrupt international money
laundering activities, thereby thwarting drug traffickers and terrorist organizations
that attempt to channel their illegal earnings through legitimate businesses. At the
same time, these new measures increased the cost of doing business, especially in
the financial services industry, by requiring banks and thrifts to take a much more
active role in monitoring and reporting suspicious transactions.
Existing commentary on the Patriot Act has focused on its implications for civil
liberties and constitutional rights, examined regulatory implementation and
compliance issues from a practitioner’s perspective, and evaluated the likely
effectiveness of Title III’s AML provisions in disrupting terrorist financial networks.
We are not aware, however, of any empirical analyses of the distribution of the
compliance burden among the institutions that, since 9/11, have been on the frontlines
of the fight against the financing of terrorist activity. It has been our purpose in
this study to develop and estimate a model which allows testing the intra-industry
effects of new AML regulations on US financial institutions.
Using a dataset comprising more than 150,000 observations on from all
FDIC-insured commercial banks and thrifts in operation between 1992 and 2005, we
find evidence suggesting that compliance with the AML provisions of the Patriot Act
has transferred wealth from small institutions to large institutions. Specifically, the
elasticity of TEXP with respect to institution size is significantly smaller in the
post-Patriot Act period than in the pre-Patriot Act period, indicating that an increase in
firm size results in a less than proportional increase in compliance costs, ceteris paribus.
This result is consistent with a heterogeneous-firm model of regulation, which
suggests that requiring all firms to comply with the same regulatory standards can
make lower-cost firms better off. One size evidently does not fit all. In addition, other
empirical findings reported here do not lend support to an alternative, public-interest
theory of regulation. We do not find that institutions which are more probable targets
of money launderers, such as banks with commercial-client as opposed to
agricultural-client specializations, institutions headquartered in metropolitan areas
and in states in closer proximity to national borders or foreign markets, have borne
higher compliance costs than ones which are less probable targets.

Notes
1. See Altrogge and Shughart (1984) and Anderson et al. (1988), among others.
The Robinson-Patman Act of 1936, which made it unlawful for firms to engage in price
discrimination, clearly benefited small locally owned retailers at the expense of the more
JMLC efficient national chains; earlier, in the legislative maneuvering leading to passage of the
antitrust statute bearing his name, “Senator John Sherman of Ohio was the cat’s paw of the
10,3 well-organized Ohio petroleum producers, dominated by small firms that Standard Oil had
driven out of business with a combination of lower costs and anticompetitive practices”
(Hovenkamp, 2005, pp. 41-2 and 192-3).
2. Other estimates of compliance costs are of the same magnitude. Citing a study conducted by
314 Celent Communications, a US-based consulting firm, Der Hovanesian and Fairlamb (2003)
state that US financial institutions have spent more than $11 billion in implementing new
AML procedures.
3. The definitions of the size categories used in this study are consistent with those used by
Critchfield et al. (2004) and the FDIC’s Risk Analysis Center (2006). Large banks and thrifts
are defined as institutions with assets totaling more than $10 billion. Midsize banks and
thrifts consist of institutions with total assets ranging between $1 billion and $10 billion.
Large community banks and thrifts are institutions with total assets in the $500 million to
$1 billion range. Small community banks and thrifts are those with less than $500 million in
total assets. The CPI deflator is used to convert all class sizes to constant $2005.
4. Note that interacting all of the independent variables with POST is the same as estimating
two separate regression equations, one for the years before the Patriot Act and one for the
years afterwards (Wooldridge, 2000, pp. 412-3).
5. Darnell (1980), McKinsey & Company (1992), Barefoot et al. (1993), and others estimate and
measure the regulatory costs of financial institutions in terms of their total non-interest
expenditures (Elliehausen, 1998).
6. Altrogge and Shughart (1984) use a similar approach in testing whether the civil penalties
assessed by the Federal Trade Commission on violators of cease-and-desist orders increase
more or less proportionately with firm size.
7. According to the FDIC (2006), the business specialization categories are developed by FDIC
analysts based on industry standards, experience, and data testing. The goal is to set
meaningful thresholds that are reasonably populated and easy to replicate in each report
prepared by an institution. Each specialization category has a different background or
target. For example, the agricultural specialization category is a venerable FDIC industry
standard.
8. The Office of Management and Budget defines metropolitan areas “in terms of entire
counties surrounding central cities, except in the six New England states where they
are defined in terms of cities and towns within counties” (Federal Deposit Insurance
Corporation, 2006).
9. The before-and-after difference here is significant at the 1 percent level on a one-tailed test.
The same conclusion holds for all other pre- and post-Patriot Act comparisons discussed
below. Table IV provides a summary of the before-and-after results.
10. In order to explore further, the relative change in total non-interest expenditures after the
Patriot Act, we estimated additional regression specifications where the dependent variable,
RATIO, was defined as the ratio of total interest expenditures to total non-interest
expenditures of banks and thrifts. The model included dummy variables for the post-Patriot
Act years, 2002-2005, so that the base group consists of observations from the pre-Patriot
Act period. Included as control variables were the average annual interest rate on
three-month certificates of deposit (CDs) posted by the Fed and each institution’s total
deposits. We estimated versions of these regressions for the banking and thrift industry as a
whole as well as for four sub-samples classified by institution size, namely, large commercial
banks and thrifts, midsize commercial banks and thrifts, large community banks and thrifts,
and small community banks and thrifts. The results of these estimations yield conclusions
 similar to those drawn from Table III: small and large community banks and thrifts, on The wealth
average, experienced substantially lower ratios of total interest expenditures to total
non-interest expenditures in the post-Patriot Act period, ceteris paribus. On the other hand, effects of the
large institutions, on average, saw an increase in their interest relative to non-interest USA Patriot Act
expenditures over the same period, ceteris paribus. Holding the three-month CD rate and
total deposits constant, a higher (lower) ratio of total interest expenditures to total
non-interest expenditures indicates a relative decrease (increase) in total non-interest
expenditures. These additional results are available upon request. 315

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USA Patriot Act

Corresponding author 317

William F. Shughart II can be contacted at: shughart@olemiss.edu

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