Dodd Frank: Repeal and Replace?
The 2016 U.S. election was among the most colorful and dramatic in our history. While it remains to be seen how consequential it will be, one potential impact of particular interest to us at Bear Mountain Capital is the fate of the 2010 Dodd-Frank Act.
Dodd-Frank was a complex legislative package enacted with the broad goal of preventing a repeat of the 2007-2008 financial crisis. Shortly after taking office, President Trump declared the legislation a “disaster” and promised to “do a big number” on it.[1] And while the President has not revealed the full scope of his plans, he has already taken concrete steps to roll back certain aspects of Dodd-Frank. Since further challenges to the legislation appear likely, we have prepared the following summary of Dodd-Frank, its goals, the trade-offs it makes in pursuit of those goals, and what aspects may be changed by the Trump Administration and the Republican-controlled Congress.
In a nutshell, Dodd-Frank was the second, systemic half of the U.S. government’s response to the financial crisis of 2007-2008. That crisis was the most severe threat to the nation’s economy since the Great Depression, and its negative effects continue to reverberate around the world. It erupted when dozens of financial institutions, including the largest banks in the country, discovered that they had taken on large amounts of complex debt they did not fully understand, much of which rested on unsustainable real estate prices. When the real estate market cooled off, these banks reluctantly acknowledged that they had far less capital than they once thought. Some had so grossly misjudged their assets they were forced into bankruptcy. And even banks that stayed in business were in no condition to extend further credit to anyone, even stable, profitable businesses.
Credit is the lubricating oil of business. Companies use bank financing and other forms of debt in a myriad of ways, such as replacing aging equipment, covering cash flow shortages in off-revenue cycles, paying for expansion plans, or for contingency needs during unexpected events, such as the financial crisis itself. Credit is critical for small businesses, allowing them to ride out the inevitable unknowns of operating their business through thick and thin. Even profitable companies with steady cash flow typically use credit for these purposes, and nearly every business has customers who pay for goods and services using credit.
When credit dried up in 2007, the results were nearly catastrophic. The Dow Jones Industrial Average lost 50% of its value in 18 months. The unemployment rate doubled to over 10%. Wall Street banks that had financed global business for a century closed their doors. Major American manufacturers faced bankruptcy. Given entrepreneurship is highly dependent on young businesses being able to secure credit, the most chilling effect of the crisis, as shown below, was that new business formation was cut in half:
(https://www.bls.gov/bdm/entrepreneurship/entrepreneurship.htm)
The government’s initial response to the crisis was a series of direct actions, mainly using government loans and credit guarantees to strengthen the balance sheets of large financial institutions, including AIG, JPMorgan, Bear Stearns, and Goldman Sachs, two of the major U.S. auto manufacturers, and many smaller firms. It was the first step in ensuring some of the nation’s largest institutions remained solvent.
Once this phase of the crisis had passed, Congress bundled a wide range of measures into the 848-page Dodd-Frank Wall Street Reform and Consumer Protection Act. Dodd-Frank includes far too many specific measures to discuss here, but at a high level it did four things:
- It substantially restructured the regulatory regime that oversees the U.S. financial industry, consolidating many of the existing regulatory agencies, reorganizing their functions, and creating a significant new regulatory body, the Bureau of Consumer Financial Protection.
- It altered many of the rules themselves. For example, it imposed greater transparency requirements on the trading of derivatives, the complex securities many blamed for the crisis itself, and it tightened the requirements for issuing home mortgages.
- It imposed greater capital requirements on a broader range of financial institutions. Under Dodd-Frank, banks and other debt-issuing entities have to maintain more assets relative to the size of their loan portfolios. Particularly large financial institutions—those deemed “too big to fail,” because their collapse would put the entire system at risk—are subject to even more stringent capital requirements, and the government now has greater power to intervene in their management if they appear at risk of failure.
- Finally, Dodd-Frank established a firewall between commercial and investment banking through what is known as the Volcker Rule. For most of the 20th century, banks had to choose between either taking deposits and making loans (commercial banking) or making speculative investments, such as equity investments in other companies (investment banking, or more specifically, “proprietary trading”). That distinction was created by the Glass-Steagall Act (essentially the Dodd-Frank of the Great Depression) but gradually eroded through legislation and rule-making. It was eventually done away with in 1998. The rationale for the division is that investment banking is far riskier than commercial lending, and heavy losses in investment banking had the potential to wipe out commercial banking deposits or prevent commercial banks from making loans. The Volcker Rule does not require that commercial and investment banks be separate entities, but it prohibits banks from using commercial banking assets (i.e. deposit accounts) as investment capital for investment banking activities.
So, what would a “repeal” of Dodd-Frank look like? An outright repeal of the entire legislation is highly unlikely. But we can expect a series of challenges to components of the legislation. Indeed, one Dodd-Frank reform, the requirement that oil companies report payments they make to foreign governments, was eliminated by the very first piece of substantive legislation to reach President Trump’s desk.[2] Other focused repeals and revisions are expected to follow.
A major piece of Dodd-Frank that is under fire is the Bureau of Consumer Financial Protection. Intended to bring greater transparency and fairness to consumer financial products such as credit cards and mortgages, it has been the subject of legal and political disputes throughout its short life. Congressional Republicans have introduced legislation to weaken or abolish the BCFP, and Congressional Democrats, for whom the BCFP is a signature issue, will put up considerable resistance.[3]
Besides the BCFP, the major aspects of Dodd-Frank that are most likely to see revision are the limitations on loan making—both the capital requirements and the Volcker Rule. Critics assert that these provisions unduly limit lending which in turn limits economic growth. Secondarily, critics assert that the cost of compliance with the requirements (record keeping, reporting, oversight, etc.) are themselves a substantial drag on the profitability of banks, and thus, on their loan making.
These criticisms notwithstanding, commercial lending in the U.S. is at record levels, far higher than in the years preceding the financial crisis, and a smaller percentage of business owners report being unable to secure loans than before the crisis.[4] The following chart illustrates the amount of commercial and industrial bank loans in the market from 2007 to 2017:
(http://money.cnn.com/2017/02/14/investing/janet-yellen-dodd-frank-trump/)
Dodd-Frank’s capital requirements and the Volcker Rule reflect a trade-off. Any limitations on the ability of banks to lend money will act as a drag on economic growth. But if well designed, those limits also reduce the chances of a credit crisis, which can have negative repercussions that last a decade or more, as the illustrated by the ongoing repercussions of the 2007-2008 crisis in the United States and abroad.
Bear Mountain Capital Inc. believes these costs are worth it. Those who would repeal these aspects of Dodd-Frank must do more to make their case than assert that Dodd-Frank impairs commercial lending. They must explain how alternative regulatory schemes (or the absence of a regulatory scheme) would protect the nation’s economy from a repeat of the crisis of 2007-2008. If we can maintain a middle ground, ensuring long-term financial stability, while also providing consumers and small business access to the credit they require, our economy will benefit.
[1] http://money.cnn.com/2017/01/30/investing/dodd-frank-trump-regulation-banks/
[2] http://www.economist.com/blogs/democracyinamerica/2017/02/big-signing
[3] http://www.latimes.com/business/lazarus/la-fi-lazarus-cfpb-republican-bills-20170221-story.html
[4] https://www.washingtonpost.com/news/fact-checker/wp/2017/02/09/trumps-claim-that-friends-cant-borrow-money-because-of-dodd-frank/?utm_term=.da9002a506ad