Wharton's Peter Conti-Brown and Lisa Cook from Michigan State University discuss what lies ahead for banking in 2019.

The U.S. banking industry is in better shape since the 2008 financial crisis, thanks to stronger capital buffers and other reforms brought by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. However, it faces vulnerabilities on several fronts with the Trump administration undermining regulatory oversight, according to experts.

Peter Conti-Brown, Fed expert and Wharton professor of legal studies and business ethics, and Lisa Cook, associate professor of economics and international relations at Michigan State University, shared their perspectives on the outlook for the banking industry for the “2019: A Look Ahead” series on the Knowledge at Wharton radio show on Sirius XM.

In the past year, several banks ran into regulatory trouble and faced hefty fines and other penalties, including Deutsche Bank for facilitating money laundering, Wells Fargo for falsifying and manipulating customer accounts, and Citibank for alleged lapses in handling American Depository Receipts.

Those transgressions strengthen fears that similar or other violations are not entirely behind the banking industry. It helps that the Federal Reserve is stepping up supervisory oversight. It has also acted to prevent overheating of the economy by steadily raising interest rates, even as it draws the ire of President Trump, who prefers a tamer interest-rate regime.

Legal Risks the Most Alarming

Conti-Brown acknowledged that U.S. banks are better capitalized today than they were in 2008, and the mishaps with structured finance during the financial crisis have not reappeared. However, he thought it “a fair critique” that worries of financial strife persist. “Memories are exceedingly short, and that’s a truism for the trading desk,” he added.

Conti-Brown said the bank executives “who lived through the trauma of 2008” were responsible for some recent lapses as well, though they are taking different types of risks. “We’re seeing a set of spectacular risk-taking around legal liability that is and continues to be very troubling,” he said. “What I’m more worried about, frankly, is just how much legal risk these banks have been exposed to, in particular on questions of fraud.” He cited the recent bribery scandal involving Malaysia’s sovereign wealth fund 1MDB and Goldman Sachs, as well as Deutsche Bank’s violations, as examples.

“We’re seeing a set of spectacular risk-taking around legal liability that is, and continues to be, very troubling.” –Peter Conti-Brown

For Cook, shadow banking is the top concern, where private equity firms and other non-depository financial institutions continue to escape regulatory oversight. “That is where a lot of the big risk is coming from,” she said. “We hear the headlines about Wells Fargo and about bank capital. What we don’t hear as much about are the private equity firms and the kinds of derivatives that undermine the financial system.”

Risks with AI in Banking

One new concern is how the banking industry uses artificial intelligence to make credit decisions, said Cook. “Many of these algorithms amplify a number of biases contained in the decision making of human beings,” she added. “You may have a lot of people kicked out of the financial system, and often these are the folks who would be the large consumers who would contribute to the economy and would spend a lot of money.”

Cook also worried that AI tools focused on large deals might end up restricting access to credit for small entrepreneurs. She noted that the “the Federal Reserve is reacting to that by doing more machine-learning itself and incorporating more AI into its own analysis.”

Cook also felt consolidation within the banking industry is not necessarily the best way out of its crises. “There is no such thing as an optimal size of a bank,” she said. “Larger and larger banks are vanity projects. I’m not sure if any good can come from this, and the larger they become, ‘too big to fail’ becomes much more of a reality.”

Oversight Abandoned, Fed to the Rescue

Conti-Brown explained why he thought stronger oversight over banks is critical at the current juncture. “The untold story about 2018 is the evacuation of financial stability field by the Financial Stability Oversight Council (FSOC) and the Office for Financial Research (OFR),” he said.

These two new entities that Dodd-Frank created were seen as the solution to the problems that defined the 2008 financial crisis, including the growth of shadow banking and the “pockets of contagion that they can create outside the formal banking system,” he added. Even if one were to acknowledge that the FSOC and OFR have their flaws, “what we’ve seen in the last two years is that they’ve essentially been gutted or just abandoned the work of financial stability oversight,” he said.

The Federal Reserve has stepped in to fill that gap and has published a Financial Stability Report, with the promise that it would publish such a report every year. “Does that mean that the Fed now is taking a stand and saying that it will be the financial stability regulator for the U.S. economy?” asked Conti-Brown.

“If that’s true, that’s remarkable, because that very question was debated at great length in 2009 and 2010 and it was determined that no, the Fed should not hold the keys of the financial stability kingdom,” Conti-Brown continued. “But I don’t blame the Fed for saying that it has to stand up here, because if they don’t who will?”

Cook said that through its actions, “the Federal Reserve system recognizes that it has coordination power that is not located in other parts of the government, including coordination power with other central banks.”

Stronger Oversight on the Way?

Cook believes Democrats would push for stronger regulatory oversight of the banking industry, armed with their new majority in the House of Representatives. She noted that Democratic Congresswoman Maxine Waters of California, who was named the chair of the House Financial Services Committee, “is very concerned” about strengthening bank supervision. “Many consumers are relieved, if not delighted, that the Democrats will be back in charge of the Financial Services Committee and will have some oversight over the Consumer Financial [Protection Bureau],” she said.

Added Conti-Brown: “Now that the Democrats have the gavel [in the House], they’re going to be using this to investigate not only bad practices from banks but also throughout the Trump administration.”

“Larger and larger banks are vanity projects … and the larger they become, ‘too big to fail’ becomes much more of a reality.” –Lisa Cook

Politicizing the Fed’s Moves

One area where the Federal Reserve has little control is in the politicization of its monetary policy moves, following criticism from President Trump about its rate hikes. That has also generated some misplaced controversies about the Fed’s independence, according to Conti-Brown.

“There’s so much misunderstanding about what it means when we say that the central bank – the Fed in this case – should be independent,” Conti-Brown said. “Independence is not an all or nothing phenomenon. You don’t turn on the switch and all of a sudden, the Fed is independent, and turn it off and ceases to exist. The Fed exists within a political environment that has and needs mechanisms of accountability and legitimacy. And so, criticizing Fed policy, and wanting to know more about the people who sit in those chairs who decide all that, is extremely healthy.”

However, Trump’s misgivings about the Fed’s policies have distorted those debates. “The problem with what Donald Trump has done in attacking the Fed is that now everything the Fed does is refracted through the prism of presidential politics, even when it has absolutely nothing to do with the president,” Conti-Brown said. He pointed to The New York Times and CNBC as among the media outlets that have been reading the Fed’s actions as pro-Trump or anti-Trump.

Conti-Brown said that is “because people love a fight and that’s what they’re going to focus on.” It doesn’t help that the Trump administration has allowed those perceptions to persist, he suggested. “This is one of the most stunning political masked miscalculations that Donald Trump may have made, because this kind of criticism can only hurt him.”

On its part, the Fed has made it clear that it will not capitulate to Trump’s desires. Cook noted that Fed chair Jerome Powell said at a recent meeting of the American Economic Association that he would not resign if asked to by the president.

Cook said that the Trump-Fed tussle has gone too far. “Certainly, all presidents have had their qualms with Fed chairs or the decisions of the Federal Reserve System, but this seems to be quite a bit of overreach,” she said. Cook attributed the current controversies to “a misunderstanding about what the Fed does and why its independence is important.” She pointed out that many studies show that the economies of countries that don’t have such an independent Fed have higher inflation rates, for example. “It’s very dangerous for us to be going down that path.”