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WorldMarch 1 2017

Dodd-Frank: the defence

A US regulatory overhaul has been welcomed by many who believe Dodd-Frank has spawned too many regulations and prevents smaller banks from lending. However, there are concerns that the replacement Financial Choice Act will sweep away many of the safeguards designed to prevent a repeat of the 2008 crisis. Jane Monahan reports.
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Wall Street

With US president Donald Trump’s announced review of the Dodd-Frank Act, the pushback on US post-crisis financial regulation has begun.

Mr Trump has said he will “do a big number” on Dodd-Frank, calling it “a disaster”. Both he and Gary Cohn, the White House National Economic Council director and recent Goldman Sachs chief executive, mainly frame their opposition around one area.

They argue that the plethora of rules and regulations arising from the act constrain the US banking system – especially small banks – by making it too difficult to lend on sensible terms to small businesses and homebuyers, thus impeding economic growth and consumer choice.

Republican support

This portrayal, widely considered logical and reasonable, has the support of the Republican leadership in Congress. At a February 14 monetary policy meeting, Mike Crapo, the Idaho Republican who heads the Senate Committee on Banking, Housing and Urban Affairs, said: “We all need to better understand the combined impact of these rules on lending, liquidity, costs for small financial institutions and broader economic growth.” 

More generally, it is acknowledged, including by opposition Democrats, that an overriding aim of Dodd-Frank – which was created in the wake of the 2008-09 crisis – is to ensure the stability of the financial system, contain the risks of the largest, most systemic financial institutions and prevent a repeat of the reckless and aggressive lending practices that fuelled the US subprime mortgage meltdown. 

Nobody disputes that the largest US banks – JPMorgan Chase, Bank of America, Wells Fargo, Goldman Sachs, Citigroup and Morgan Stanley – are in an incomparably different situation today. Mr Cohn said on Fox Business Network that one of the competitive advantages of US globally systemically important banks (GSIBs), compared with their European counterparts, is that they are the most highly capitalised banks in the world.

Paul Merski, vice-president of the Independent Community Bankers Association, which claims to represent about 5000 of the estimated 6000 small US banks, says: “Our main concern is that these rules and regulations that were put in place to address systemically risky institutions impacted the entire financial system, down to many of our community banks.

“It makes a big difference if a community bank that is a $10bn institution has to [abide by] most of the same rules as a $1000bn institution, and compete with the cost.” 

Could the pendulum swing?

Notwithstanding this, some commentators and US credit rating agency Fitch Ratings warn that deregulation and a broad overhaul of Dodd-Frank carry the risk that the pendulum could swing too far in the opposite direction.

This is because the Financial Choice Act (FCA) – the draft law in Congress that will essentially replace Dodd-Frank – contains sweeping proposals. But these proposals are not limited to freeing small banks (those with assets of between $10bn and $50bn) from stress tests, less frequent resolution planning and less powerful regulators.

The FCA – which was introduced in 2016 by Texas Republican Jeb Hensarling, who heads the House Financial Services Committee – also aims to make the system less risk averse, for example, by lifting the Volker Rule ban on proprietary trading. And, in a major departure, the FCA proposes that banks can exempt themselves from Dodd-Frank’s supervisory regime if they meet a 10% or higher leverage ratio requirement.

In February, a special report by Fitch, entitled 'the impact of US financial market deregulation', estimated that small banks could most easily benefit from the exemption. But for US GSIBs, the cost of the additional capital needed to qualify for “off ramp” exemption – about $400bn or more of Tier 1 capital for all US GSIBs combined – would outweigh the benefits of the regulatory relief.

The largest US banks are also unlikely to take advantage of the proposed exemption because most Dodd-Frank rules have already been implemented (about 90%) and banks have already invested heavily in back-office infrastructure to comply. JPMorgan Chase, the country’s largest bank by assets, hired about 20,000 professionals to deal with Dodd-Frank, according to Thaya Brook Knight, associate director at the Cato Institute.

Stephen Matteo Miller, a senior research fellow at the Mercatus Center, a conservative think tank at George Mason University, supports the FCA reforms. “I would just have a flat capital ratio, like a leverage ratio – equity-to-assets or equity-to-liabilities – applied to all entities, and to on- and off-balance-sheet items. That would replace the need for all the other regulations,” he says.

“But the FCA does not include the off-balance-sheet requirement for all financial institutions. That’s a hole in the act. I would also suggest a higher flat leverage ratio, about 15%, but I know the banking industry would be up in arms.”

Capital is not enough

Meanwhile, Daniel Tarullo, a Federal Reserve Bank governor and arguably the most influential regulator of the US banking system of the past eight years, has said big capital cushions alone cannot ensure the stability of the US financial system. Mr Tarullo has resigned from his position from April, further boosting the Trump administration’s plan to ease rules for banks.

According to Fitch analysts, Democrats and some regulators, the main concern about the FCA centres on proposals to eliminate safeguards established under Dodd-Frank to address systemic risks and issues around ‘too big to fail’ banks.

The authority of the newly created Financial Stability Oversight Council, which was designed to identify and act upon systemic risk, would be removed, and the Orderly Liquidation Authority (OLA) eliminated. In their place, the US Bankruptcy Code would be amended to deal with a bank failure, should it occur.

But Joo-Yung Lee, head of North American financial institutions at Fitch, says: “OLA was never intended to be a bailout. It was put in place to ensure, if a financial institution could not be resolved through a bankruptcy procedure, that regulators would be provided with another avenue, to allow them to ensure an orderly liquidation – sort of [a] temporary power to ensure financial stability. Anything that was used to recapitalise an institution by OLA would have to be collateralised anyway.”

Further concerns

The proposed changes also mean that if a large non-bank financial institution were to grow and become systemically important, there would be no authority to regulate it.

On top of that, the FCA proposes further limiting the Federal Reserve’s emergency lending authority – an idea the Fitch report claims “could reduce [the Fed’s] effectiveness as a central bank, particularly during periods of financial stress or systemic risk, a key purpose of the Federal Reserve”.

Many of the emergency powers of the Federal Deposit Insurance Corporation (FDIC) provided by Dodd-Frank would also be removed. This includes the FDIC’s capacity to determine when a systemic risk exists and its ability to provide guarantees to uninsured deposits or non-deposits with the fund.

In summary, on the positive side, the system would be more market orientated and banks will be freer to lend; there will be more consumer choice; and a lighter regulatory burden should lead to less compliance costs, at least for smaller banks, helping their profits. On the other hand, the discipline of the market will prevail, and if a bank gets into trouble, it would almost certainly be allowed to fail.

Overhauling Dodd-Frank, therefore, could lead to a reopening of the debate on how to solve the problem of banking behemoths without bailouts or government backstops. The danger is that this could increase banks’ cost of capital if markets become convinced a big bank could fail.

Much would depend on what government is in power. But Fitch’s Mr Weinfurter says: “The overall intent of Dodd-Frank is to ensure that large GSIBs could be allowed to fail and that this would not impact the broader financial system. This is because losses would be imposed on equity and debt holders, the capital would be restructured and contagion would be contained across the financial system.

“Anything that goes against the power of regulators to do that [and] the market begins to be unsure about how that might be done in a future crisis. There would be more questions about the ability to address systemic risks.” 

Dwindling board

Meanwhile, under the FCA, regulators would be brought more under Congressional control, through more cost-benefit analysis on various rules, more control over regulators’ budgets and a restructuring in the way various regulators are led. The latter would have most impact on the Consumer Financial Protection Bureau, the FDIC and the Fed. Indeed, with Mr Tarullo’s announced departure, the number of vacant seats on the Federal Reserve Board will rise from three to seven, while Janet Yellen’s term as Fed chair also expires early in 2018.

Added to this, the Fed’s recently tiered Comprehensive Capital Analysis and Review, or CCAR, stress tests (they are more lenient for banks with assets of between $50bn and $250bn than for banks above that threshold) would be subject to public notice and comment. This could delay how quickly the Fed could respond to changing events, such as an asset bubble or another sudden risk, and could also affect the timeliness of the risks addressed in the tests, according to Fitch.

“That is something we will continue to look at. It may not have individual [bank] rating consequences, but it certainly may weaken the regulatory environment,” says Ms Lee.

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