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Idaho Senator Mike Crapo’s Economic Growth, Regulatory Relief and Consumer Protection Act, a bipartisan bill that was signed into law on May 24, brings big relief for large banks and community banks. The act raised the threshold for banks that are required to undergo stress tests from $50 billion to $250 billion, thereby reducing the number of big banks that are considered too big to fail. It could also expand access to finance for small and medium-sized enterprises by freeing controls on small and local community banks with assets of under $10 billion.
However, experts are worried about the likelihood of unpleasant outcomes. If reduced oversight results in consolidation within the community banking industry, small banks could become less sensitive to the needs of their regional economies and communities that are typically underserved by the larger banks, they said. Loosening the so-called Volcker Rule (named after former Federal Reserve chairman Paul Volcker) could also expose bank customers to risks, they added. The rule prevented banks from risky activities such as proprietary trading in securities and investing in certain types of hedge funds and private equity firms.
“This effort to change the regulatory requirements on mid-sized and regional banks is reflective of a cycle we sometimes see in financial regulation, which is there’ll be a crisis, a disaster, and then Congress will pass relatively intensive regulations designed to stop the last war from happening again in the future,” said David Zaring, Wharton professor of legal studies and business ethics. The Dodd-Frank Act is an example; it was designed to prevent occurrences like the 2008 financial crisis. “When times get better, there tends to be a lot of pressure from the industry to reduce regulatory requirements.”
Zaring noted that legislators are often receptive to easing regulatory requirements “because the good times are rolling” and there hasn’t been a financial crisis since 2008. “Memories are short. Even if history repeats itself, there’s often an effort to deregulate,” he said. However, deregulation is not always bad, and regulations could be “overly intensive” and may need correction, he added. He said that unlike other countries, the U.S. has a relatively larger proportion of small and midsized banks, which found regulatory compliance overly burdensome.
“Memories are short. Even if history repeats itself, there’s often an effort to deregulate.” –David Zaring
The bill has a broader package of other regulatory relaxations covering large foreign banks that operate in the U.S., including those that recently received exemptions from penalties for violations. It also chips away at consumer protections for rural Americans, buyers of manufactured housing, and those in far flung places looking for mortgage credit.
Andy Green, managing director of economic policy at the Center for American Progress, was critical of the move to relax the Volcker Rule for banks. “We’re [seeing] the attempt to hack away at the basic principle that says that if you’re a bank that takes deposits and makes loans, you and your affiliates ought to be out of the business of making swing-for-the-fence bets in the trading markets,” he said. Green was formerly a counsel for the Securities and Exchange Commission (SEC).
Green acknowledged that “regulation always needs to be tweaked and improved,” but added that it is important to be aware of the likely outcomes. “Are we trying to improve [the financial system] to make it stronger, simpler, tougher and tighter so that [it serves] the real economy better, or are we engaged in boosting the profits, boosting the market concentration and dominance of the very largest institutions often at the expense of the real economy and ordinary working Americans? The evidence to date is that that that Trump and the regulators that he’s put in place are very much looking at trying to concentrate power and not trying to do things that protect working Americans … and taxpayers.”
Zaring and Green discussed the likely implications of the latest changes to banking oversight on the Knowledge@Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)
Easier for Some
Zaring noted that the so-called “custodian banks” – State Street, Northern Trust and Bank of New York Mellon – get substantial regulatory relief in the bill. “They’re going to be able to comply with their regulatory capital requirements more easily and use more of the assets they’re holding to count as capital. That is going to make their lives easier,” he said.
According to Green, the banks that benefit from lifting the asset threshold for supervision to $250 billion include those that were bailed out at taxpayer expense in the 2008 financial crisis. “We ought not to be thinking of this [bill] as regulatory relief or making life easier [for those banks],” he added. “We ought to be thinking about who’s going to be able to earn more off of the slim equity in these banks. Is it going to be the executives and the shareholders who get the upside, but then leave the downside to the taxpayer?”
Green pointed out that financial reform and financial regulation are essentially about accountability. “It’s about making sure the financial system absorbs its own losses, does not engage in high risk activity, and that it is for the benefit of the taxpayer.”
“Are we trying to improve [the financial system] to make it stronger, simpler, tougher and tighter so that [it serves] the real economy better, or are we engaged in boosting the profits … at the expense of the real economy and ordinary working Americans?” –Andy Green
Zaring said he was “a little less worried about the custodial banks” getting regulatory relaxations. “They are the central part of the plumbing of the [U.S.] financial system. However, I don’t think we’ve seen much evidence that they’re about to fail.”
As for the relief for small and midsized banks, Green worried about unintended adverse effects. He pointed to speculation that it would be “a bonanza” for them and trigger a rash of mergers and acquisitions. As consolidation occurs among small and midsized banks, it might impact lending and support for regional economies “often out in rural America,” he said. “The impact of this is something that troubles me.” Meanwhile, the Federal Reserve last Wednesday asked for public comment on the plan to relax the Volcker Rule for community banks (those with less than $10 billion in assets).
Most consumers have their accounts with the largest banks, and they are unlikely to see any difference in how they are treated by their institutions, according to Zaring. However, small and medium-sized businesses will benefit from the relaxations for community banks, he said. Large banks like a Bank of America or Wells Fargo may not be interested in winning business from small enterprises, but “a local bank with close roots to the community is the kind of bank that’s willing to take the time to provide them with the financing they need,” he added. “Those small firms will find financing easier and therefore will be able to grow their business to the benefit of the economy.”
Green said reducing regulatory oversight on small banks could be counterproductive. He pointed out that regional banks have seen many failures and had to be bailed out by the Federal Reserve in the past. “If [I am] a small business, or a family farmer, or even just an ordinary consumer in a part of America that is more dependent upon regional banks and community banks, I would want them to be more strongly regulated rather than be more fragile,” he said.
Other outcomes could be higher prices for manufactured homes “because there’s a greater ability for the companies selling them to steer you into mortgages and sales products that don’t work for you,” Green said. He worried also about how the new relaxations will reduce data collected and made available to the public on banks’ mortgage loans under the Home Mortgage Disclosure Act. “That data collection is now going to stop for about 75% of the banks,” he said. “There are some knock-on risks, and I just hope it doesn’t end as badly as it could.”
The Gathering Clouds
Green painted a dismal picture of the emerging scenario for protection of consumers and financial institutions. He was not happy with the dialing back of regulations requiring stress tests, monitoring of leverage ratios and capital adequacy ratios for banks. The Commodity Futures Trading Commission is also considering proposals to cut back on some transparency and market competition provisions as they relate to swaps, he noted.
“A well-regulated and well-capitalized financial system serves [the economy] better than one that facilitates booms, busts and bailouts.” –Andy Green
Green worried also about “the SEC dialing back transparency in everything from the stock markets to the bond markets.” He pointed in particular to a proposal being considered by the SEC’s fixed-income market advisory committee to exclude block trades over a certain size in the corporate bond market from certain transparency requirements. “Things like that really do start to add up one after another. At some point, you hack away enough at these things, and the dam doesn’t hold, and the results are quite problematic.”
On regulatory relaxations from the Volcker Rule, Zaring noted that the onus of proving whether or not a bank is engaged in proprietary trading shifts from the bank to regulators. He recalled a comment by JPMorganChase CEO Jamie Dimon that “complying with the Volcker Rule means that a trader needs to have a lawyer and a psychologist present at all times.”
Zaring added to that list the paring back of regulatory oversight by the Consumer Financial Protection Bureau (CFPB). He said the CFPB has stopped close supervision of auto loans, payday lenders and other “dodgy parts” of the financial system. “The idea is that consumers are going to be better served by unfettered payday lenders and title loan givers than they would be if they had protection,” he said. “That is a real change in the spirit of Dodd-Frank, and a pivoting of the CFPB from scrutinizing these industries to totally ceasing any scrutiny at all.”
Green noted that even with the tighter regulation under Dodd-Frank, banks have been quite profitable in recent years. He pointed to Morgan Stanley and Goldman Sachs making profits even after they moved away from proprietary trading after the Volcker Rule came into effect. “It goes to show you that it’s quite possible to run a financial system that serves the economy effectively and is reasonably profitable for the institutions, and the executives and employees that work there.”
At the end of the day, the role of the financial system is to support an economy, he noted. “A well-regulated and well-capitalized financial system serves that better than one that facilitates booms, busts and bailouts.”