Making American Banks Great Again?

Ten years after the onset of the financial crisis, the Trump administration is seeking to undo the DFA as part of its program of deregulation.  Fed Chair Janet Yellen, speaking at the annual August Jackson Hole gathering of central), stated unequivocally that the financial regulations introduced in the aftermath of the 2007 financial had made the system safer and more resilient, and that any adjustments to the regulatory framework should be limited. Yellen’s statement, as well as recent warnings from other Fed regional presidents, was a clear rebuttal to the Trump administration’s effort to undo the Dodd- Frank Act (DFA).

The Background: Ten years ago, the collapse of Northern Rock in the UK and Bear Stearns in the U.S. marked the onset of the worst global financial crisis since the Great Depression. The U.S. economy skated perilously close to another depression, in any case experiencing the deepest down cycle in the post-World War II era. As the economy slowly emerged from the so-called “Great Recession”, Congress enacted a comprehensive legislation overhauling the financial system regulatory framework, the Wall Street Reform and Consumer Protection Act  (aka Dodd-Frank Act, DFA), which was signed by President Obama in July 2010.  The DFA was a complex document of almost 2,700 pages, which also required about 400 new regulations, designed to prevent the kind of financial misbehavior that led to the 2007 crisis.  The major elements of the DFA were as follows:

- Designation of the largest financial institutions (both banks and non-banks) as Systemically Important Financial Institutions (SIFI), subject to additional capital requirement and regulatory scrutiny)
- The creation of the Financial Stability Oversight Council (FSOC), chaired by the Fed, as the coordinating body of the various financial regulators. The DFA also created the Office of Financial Research (OFR) as the research arm of the FSOC
- A requirement for banks to have “living wills”
- Introduction of the “Volcker Rule”, which basically prohibits financial institutions from engaging in speculative activities. In effect, the Volcker Rule prevents banks firm proprietary short-term trading of securities and derivatives
- The creation of an independent Consumer Financial Protection Board funded directly by the Fed

In addition, the banks were subject to the international Basel-III capital rules. Basel-III updated the Basel-II framework and imposed significant additional capitalization burdens on the largest banks (Globally Systemically Important Banks, G-SIBs, the international equivalent of SIFIs). Finally, both the Fed rules (Comprehensive Capital Analysis and Review, CCAR) and the DFA (Dodd Frank Stress Test, DFAST) imposed annual (CCAR) a semi-annual (DFAST) stress tests for the banks.  Between DFA, the Fed and Basel-III, the banks were effectively subject to three capital requirements: Basel-III (Risk-adjusted), a common equity simple leverage rule (Common Equity to Assets ratio of 6%), and stress-test results.

The new regulatory framework imposed a heavy compliance burden on the financial system.  However, at the same time, it improved the safety and resilience of the banking system by significantly increasing the levels of capital. Stress-testing, while cumbersome, also provided the banks with a useful risk management tool.

Banks’ Objections: The banks have spent hundreds of millions of dollars to comply with the DFA. At the same time, the banks continued their attempts to tweak the DFA, spending tens of millions of dollars over the years lobbying Congress.  The largest banks objected to the relatively low benchmark ($50 billion in assets for the bank holding company) for the SIFI designation and opposed the Volcker Rule, among other objections. The community banks, for their part, claimed with some justification,  that they did not represent the same systemic risk as the larger banks, and therefore should be exempt of some of the more cumbersome regulations.  The banks (and their Republicans allies in Congress) also tried to undermine the CFPB.

Deregulating Zeal: The election of Trump has provided an opening to the banks. Clearly, as in any regulatory system, the DFA needed updating.   Nevertheless, we have to separate the legitimate concerns of the banking system from those which are driven by an ideological opposition to regulation. In addition, the Republican-dominated House of Representatives passed the Financial Choice Act last June.  Both of these initiatives are aimed at gutting the DFA.

The framework of the new administration’s effort to undo the DFA was presented in the June 2017 Treasury report:” A Financial System that Creates Economic Opportunity”. The document, which basically does Wall Street’s bidding, is a hodgepodge of clichés, opinions disguised as factual statements and platitudes, all under the guise of unleashing free market forces, promoting growth, and improving the operations of the banking system.

The Treasury report makes the incredible claim that the regulations introduced by the DFA were “unrelated to the problems leading to the financial crisis”. Obviously, the Treasury under the Trump administration either does not understand the concept of macroprudential financial regulations or failed to read the thousands of studies made after the financial crisis on this topic

The Treasury main proposals can be summarized as follows:

- Bringing the OFR and the CFPB under Treasury authority
- Reducing the number and frequency of stress tests
- Eliminating some stress tests for community banks and banks which are strongly capitalized
- Exempting banks with less than $10 billion in assets from the Volcker Rule
- Re-examining the application of Basel III capital rules to American banks—in particular the capital surcharges imposed on the largest banks

The Treasury process, which reflects heavy lobbying by the banks, as well as their influence in the White House—economic policy is run by Godman Sachs alumni-- clearly politicizes the regulatory process to the banks’ advantage.The appointment of industry-friendly heads of the various financial regulators and to the Fed’s Board of Governors further enhances the influence of the banking system.

Janet Yellen, as well as Mario Draghi, the president of the European Central Bank, have stressed two points. First, there is little evidence that tougher bank regulations have caused some slowdown in credit growth. Second, even if there was some slowdown in credit growth, it is preferable to the financial system seizure that we experienced in 2008.Finally, Yellen warned against fading memories of the 2008 disaster.While banks are better capitalized than ever, regulators must remain vigilant and have the tools to prevent/mitigate another financial crisis.