The Dodd-Frank Act’s much-predicted apocalypse may be more of a prolonged whimper than the anticipated bang.
The nation now has a President zeroed in on deregulation and Congressional majorities likely to empower any such effort. Things, however, are not quite that simple. Just as “repeal and replace” proved to be a Pandora’s box of political woes when the devil leaped from the details, so too it is with regulatory reform.
What should replace the chiseled-away parts of Dodd-Frank? Do we retreat entirely from international standards like the Basel III accord, as some are calling for? Is Dodd-Frank, on balance, helping keep U.S. markets safe, or tanking them with impossible, uncompetitive demands?
How speedy will reforms be? The question is an interesting one given that some Republican leaders have, with caution, recently suggested that the bulk of regulatory reforms will likely trickle down in 2018, rather than with the blitzkrieg anticipated for this year.
For its part, the House Financial Services Committee is refreshing its stockpile of ammunition and rhetoric. Setting aside the copious amounts of politicking at some of its recent hearings, we took a look at what some of the experts who testified had to say.
Is the Volcker rule helping the economy, or is a spanner in the works?
On March 29, a House Financial Services—through its Subcommittee on Capital Markets, Securities, and Investment—held a hearing that, in essence, sought to answer the above question.
Controversial since its inception, the rule prohibits U.S. bank holding companies and their affiliates from engaging in “proprietary trading” and from sponsoring hedge funds and private equity funds.
The Securities and Exchange Commission, Office of the Comptroller of the Currency, Commodities Futures Trading Commission, Federal Deposit Insurance Corporation, and Federal Reserve jointly determine Volcker compliance and enforcement.
The multibillion-dollar question is whether the rule is preserving systemic integrity by reducing the likelihood of bank failures and bailouts, or dragging down the capital markets broadly, diminishing liquidity, and harming the functionality of fixed income and securitization markets. Other critical laments: harming the ability of U.S. and international businesses to finance their operations; U.S. competitiveness; and creating an unhelpful headwind for job creation.
Firmly in the “harming markets” camp is Ronald Kruszewski, chairman and CEO of Stifel Financial. He testified on behalf of the Securities Industry and Financial Markets Association.
In his view, “the Volcker rule needs to be taken off the books, repealed.” If repeal is not possible, “it must be materially amended to avoid further damage to the markets my company serves.”
The rule, as formulated, implemented, and enforced “has had a deleterious impact on the ability of American businesses to raise capital and grow the economy,” Kruszewski said. “[It] discourages legitimate and needed customer-supporting market-making activities by imposing an overly complex and intent-based compliance regime. To determine whether an activity was proprietary trading or legitimate market making, a compliance expert would also need to be a psychiatrist trained in determining the intent of each trade by a trader.” The rule, he argued, has raised the cost of capital for businesses.
“Contrary to theories that the Dodd-Frank Act has stifled growth, the financial sector has had record profits.”
Michael Calhoun, President, Center for Responsible Lending
Among Kruszewski’s complaints: the rule is beyond complex. The regulatory rule text is more than 950 pages and includes 2,800 footnotes. “You need a team of law firms—not just lawyers—to be able to decipher it, and even then, many times the answer is that there is no clear answer.”
The Volcker rule also includes a provision, called “RENT-D,” that “only the government could devise,” he said.
RENT-D limits market making so it does not exceed the “reasonably expected near-term demand” of clients, customers, and counter-parties. “Seven years after the enactment of Dodd-Frank, I am no closer to understanding what that term means or how to implement something so amorphous,” he said. “The ability to provide market liquidity requires an anticipation of supply or demand, which if proven wrong with the benefit of hindsight, would violate the Volcker Rule.”
Not least of all, in Kruszewski’s view, compliance is governed by five separate agencies, each with their own congressional mandate, philosophy, and approach. “It creates an uncertain and unwieldy bureaucracy,” he said. “In turn, this leads to numerous and overlapping exams and inquiries. Furthermore, this has resulted in an utter lack of guidance, under an overly complex rule that is screaming out for interpretations and FAQs.”
If not repealed, Kruszewski said, the Volcker Rule should be modified to: reverse language that assumes all trades are proprietary unless proven otherwise; and eliminate the “reasonable expected near-term demand” requirement.
Any changes should be consistent with established principles: the rule should not impede market liquidity and capital formation; the restriction on proprietary trading should be plainly written and not based on trader intent; and restricted proprietary trading should limit only trading wholly unrelated to customer activity or risk management.
Also: The regulatory regime should be rationalized with a single agency responsible for implementing, interpreting, and enforcing the rule; and restrictions on covered funds should target indirect, impermissible proprietary trading.
“The Volcker rule was never intended to apply to registered funds,” argued David Blass, general counsel of the Investment Company Institute. “Nonetheless, our members have been affected by the complexities and consequences of the rule, and some have had to navigate its complicated implementing regulations and the Byzantine multi-agency process for obtaining guidance and interpretations under those regulations.”
The Volcker rule has disrupted the market for certain securities in which registered funds invest, he alleged. It is also one of many factors contributing to structural changes in the fixed income markets.
Most significantly, many registered funds and their advisers found themselves within the definition of investment limits as if they were banks,” Blass explained. “For some ICI member firms, this treatment arose because the fund adviser is affiliated with an insured depository institution, even though that institution is not directly involved in the fund or asset management business.”
ACADEMIC VIEW OF A VOLCKER RULE REPEAL
The following is a selection from March 29 testimony offered by Charles Whitehead, professor of business law at Cornell Law School.
He spoke on the topic of “Examining the Impact of the Volcker Rule on Markets, Businesses, Investors, and Job Creation” and in favor of repealing the Volcker rule when called before the House Financial Services Committee.
There is certainly an argument for regulating risky trading activities. But the Volcker Rule addresses the wrong problem in the wrong way.
The Volcker rule was sold to Congress as a response to the 2008 financial crisis, an attempt to reduce risk in banks principally by banning short-term proprietary trading directly by banks and their affiliates and indirectly through investments in hedge funds and private equity funds. But why was restricting short-term proprietary trading a solution to the crisis? The answer is far from apparent and is unsupported by the facts that Congress had at the time. As Treasury Secretary Geithner testified, “most of the losses that were material . . . did not come from [proprietary trading] activities.”
Rather, many of the most significant bank losses arose from traditional extensions of credit, especially loans related to real estate.
I believe it is fair to say that the rule’s proponents were less interested in curing a particular cause of the financial crisis and more interested in championing the view that commercial banking should be separated from investment banking, particularly proprietary trading and principal investing.
By barring proprietary trading by banks and their affiliates, the rule’s sponsors hoped that utility services, such as taking deposits and making loans, would once again dominate the banking business.6 But that view reflected hope over experience. In light of the fluid and evolving nature of the financial markets, it was unlikely that regulation could force a return to the financial sector model of an earlier era when banks and bank lending were kept separate from the capital markets.
What has been the result? The Volcker rule imposes a static divide —a financial Maginot Line —between short-term proprietary trading and banking, but does so within a world where capital markets and bank loans compete for corporate lending, and fluid financial markets continue to evolve and can sweep around a fixed position.
Changes in the financial markets spurred by the Volcker Rule still expose banks to the kinds of risks the Volcker rule was intended to minimize or eliminate. Hedge funds and other, less-regulated entities whose activities can affect banks and bank risk taking picked up the proprietary trading that exited banks and their affiliates.
Moreover, in order to make up for losses in revenues, banking entities9 shifted their risk-taking activities to other businesses —increasing their risk taking, potentially through activities with which they were less familiar than the proprietary trading they were compelled to abandon.
The problems around the Volcker Rule are exacerbated by practical difficulty in implementing the rule itself. What is proprietary trading, and how is it distinguished from market-making?
When implementing the Rule, the regulators noted that it was difficult to define certain permitted activities because it “often involves subtle distinctions that are difficult both to describe comprehensively within regulation and to evaluate in practice.”
Source: House Financial Services Committee
A different view was argued by Marc Jarsulic, vice president of economic policy for the Center for American Progress. “The Volcker rule has not caused a deterioration of liquidity in the corporate bond market,” he said.
There is “little question that the post-crisis behavior of securities dealers collectively has changed significantly compared to the pre-crisis period,” Jarsulic claimed.
The total assets of securities brokers and dealers have declined from a peak value of about $5 trillion in 2008 to about $3.5 trillion in 2016, about the level they attained in 2005. Corporate bond holdings follow a similar pattern, peaking at over $400 billion in 2007, and declining to something above $100 billion in 2015.
“It seems fair to say that the exit of large banks from proprietary trading has not had a measurable effect on corporate bond market liquidity, liquidity risk, or the ability of corporations to raise funds in the capital market,” he said. “With respect to these criteria, our bond markets are functioning at least as well as, if not better than, they were in the pre-crisis period.”
Any demolition of Dodd-Frank’s preventative measures “is likely to be a very costly exercise in historical amnesia,” he added.
An effect on lending
The thesis, as proposed in the Republican-crafted description of another March 28 Committee hearing, is that lending by community financial institutions has declined since the passage of the Dodd-Frank Act, constraining consumer and small-business access to credit.
In the six years prior to Dodd-Frank, small-bank lending was more than 150 percent above large-bank lending. In the more than six years after Dodd-Frank, small-bank lending has been nearly 80 percent below large-bank lending, Republicans on the Committee claim, explaining that the regulatory burden is measurably restricting small-business and consumer access to credit.
“Regulatory overkill is cutting off access to credit for credit-worthy borrowers,” said Scott Heitkamp, president and CEO of ValueBank Texas. “The expense and distraction of regulatory compliance divert scarce funding and management resources from community lending, particularly for those marginal borrowers whose applications warrant closer review and a greater capacity for risk. These are the borrowers who get squeezed out by today’s regulatory burden.”
Heitkamp, who testified on behalf of the Independent Community Bankers of America, cited “good news” in “readily available legislative solutions.”
The ICBA developed the “Plan for Prosperity,” a platform of legislative recommendations. The plan includes nearly 40 separate legislative recommendations.
Specific legislative recommendations include Basel III amendments. “Basel III was originally intended to apply only to large, internationally active banks,” Heitkamp said. “Non-systemically important financial institutions should be fully exempt from the rule.”
In lieu of a full Basel III exemption for all community banks, and other changes the ICBA alternately proposes: an exemption from the capital conservation buffer; full capital recognition of allowance for credit losses; amended risk weighting to promote economic development; reverse punitive capital treatment of mortgage servicing; and more accurate identification of “systemic risk” than the current threshold of $50 billion for the identification of systemically important financial institutions under Title I of the Dodd- Frank Act.
The plan also calls for relief from SEC rules. Suggested rule changes include:
Providing an exemption from internal control audit requirements for banks with a market capitalization of $350 million or less (the current exemption applies to any company with market capitalization of $75 million or less).
Regulation D should be reformed so that anyone with a net worth of more than $1 million, including the value of their primary residence, would qualify as an “accredited investor.”
Repealing the Collins Amendment for non-SIFIs.
“Dismantling essential reforms, such as the mortgage ability to repay standard, or reducing the effectiveness of the Consumer Financial Protection Bureau would harm consumers, banks, and the overall economy,” countered Michael Calhoun, president of the Center for Responsible Lending, a non-partisan policy organization that targets abusive financial practices.
In the years leading up to the financial crisis, unsavory mortgage lenders and their disregard for quality underwriting practices made it “very difficult for responsible lenders to compete” and “in order to maintain their businesses and some market share, they were forced to join this race to the bottom,” he said.
Financial regulations, Calhoun argued, are not slowing economic growth or preventing lending. Financial institutions, including small banks, continue to recover from the worst financial downturn since the Great Depression. Mortgage lending, in particular, continues to steadily improve. Small banks are playing an important and growing role in the recovery.
“Contrary to theories that the Dodd-Frank Act has stifled growth, the financial sector has had record profits,” he claimed. In 2016, U.S. financial institutions had total annual profits of $171.3 billion, the highest level since 2013.
While this profit level is slightly lower than the profit level in the peak of the false housing boom in the years immediately prior to the financial crisis (2004-2006), “it remains higher than inflation-adjusted financial sector profits for any other time period since World War II,” he said. Community bank profitability has also rebounded strongly and meets pre-recession levels.
There are already several substantial regulatory provisions that acknowledge and accommodate the special role and circumstances of community banks and credit unions, Calhoun said. An additional avenue for regulatory relief could come by rethinking Bank Secrecy Act and Anti-Money Laundering rules compliance.
“BSA/AML compliance is a huge regulatory burden, especially for community banks and credit unions,” he said. “These laws carry out the critical need to prevent our financial institutions from being used by terrorists, drug dealers, and other criminals to facilitate illegal activities. Today, the onerous task of determining the true identity of owners of accounts falls on the financial institution.”
The American Bankers Association found that this compliance is “the most-costly regulatory burden” and is especially costly for smaller banks.
The Independent Community Bankers of America and others have asked that ownership information be collected and verified at the time a legal entity is formed by either the Internal Revenue Service or other appropriate federal or state agency, rather than by financial institutions. This would provide uniformity and consistency across the United States, Calhoun said. Bipartisan bills have supported this solution, and it is a reform that should be enacted.