Trump escalates era of regulatory competition

Investors in US bank equity can surely expect further gains in the weeks to come from the pushback against Dodd-Frank set in motion by the new administration last week.

On Friday, president Donald Trump signed an executive order requiring the US Treasury department to ensure from now on that financial regulation accords with the president’s new core principles.

These include: that it should foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis; that it should enable US companies to be competitive with foreign firms both in the US itself and also in those foreign firms’ home markets; and it should advance American interests in international financial regulatory negotiations and meetings.

The principles of America first, rather than global financial system stability, suddenly now dictate the approach to bank regulation.

US bank stocks shot up in expectation that executives will now begin to return to investors much of what they have described as an excess of capital held only to satisfy over-zealous regulators and that far exceeds any prudent cushion that the economic risk banks are taking actually requires.

While investors in bank stock celebrate, for bank customers the imagery could not be uglier.

Gary Cohn, former second in command at Goldman Sachs – a firm kept alive in the financial crisis only by the tax-payer funded bailout of AIG and its own swift re-characterizing by regulators as a bank – is now director of the National Economic Council (NEC), which makes the case for cutting the burden of bank regulation on the basis of promoting growth and job creation. Cohn casts regulation as an inhibitor of both.

Trump signed the executive order after meeting CEOs, including Larry Fink of BlackRock and Jamie Dimon of JPMorgan.

“There is nobody better to tell me about Dodd-Frank than Jamie,” claimed Trump, who declared his intention to cut a lot of Dodd-Frank rules that have prevented banks from lending money to his friends and their nice businesses.

The US president looked like the befuddled farmer so concerned for his flock that he has invited the grinning wolves round to re-design security on his sheepcote.

However, a lot of the imagery around the Trump presidency looks awful. The risk is that the imagery obscures some good intentions.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is a vast and multi-part patchwork of legislation that has proved hugely complex to put into effect.

The instinct to review its cumulative impact in addition to the many other regulatory changes introduced since the financial crisis is a sound one. Painstaking scrutiny is essential and, ideally, simplification of the many over-lapping rules and enforcement bodies would be welcome.

To take one obvious example: the founding notion of the Volcker rule to cast banks as agents to their customers rather than principal counterparts and competitors is clearly well intentioned, especially in light of the tendencies of banks to gouge and deceive their clients that the aftermath of the crisis revealed to be so deeply embedded in their cultures.

However, its implementation has had outcomes that now are well worth re-visiting. Credit intermediation in the US flows through the capital markets.

It is time to analyze whether withdrawal of bank capital to take short-term proprietary positions in an increasingly illiquid Treasury bond market has weakened a key underpinning of those markets, and in the process left investors vulnerable to new wolves in the form of high-speed traders that might appear like market makers from time to time, but have no core mission to facilitate customer flow.

There could be a better way, perhaps even a limited form of Glass-Steagall-style separation between bank holding companies’ deposit-taking operations and new securities trading subsidiaries – such as the old section 20 broker-dealer affiliates – offering stability to the Treasury market through dedicated capital for principal position taking.

Cohn was also critical of the onerous and byzantine requirements imposed on banks to create living wills. Euromoney has always been skeptical that the existence of these wills actually makes big banks any less of a contingent liability of the sovereign.

There is plenty in the legislative regulatory response to the crisis that looks like a well-intentioned distraction from the real task.

Instead of insisting banks carry enough capital and liquidity to survive the next inevitable downturn while pursuing the chimera of freeing tax-payers from the burden of too big to fail, more effort, it seems to us, should have gone into ensuring banks are good risk managers, equipped with fit-for-purpose technology that can feed management information systems with real-time data on aggregate risk exposures and supervised by directors with the right expertise.

So let’s encourage the new administration on this mission to review the regulations on banks, to test their efficacy, where possible simplify them and make them easier to implement and enforce.

What stops us cheerleading this effort, however, is the worry that it springs from misguided motives.

Has an excess of bank regulation really impeded economic recovery and job creation in the US? Has an excess of regulatory capital honestly prevented lenders from pricing affordable loans suitable to US customers with the cash flow, collateral and character to service them?

JPMorgan made $25 billion in profit in 2016. If it was failing to fulfil its societal duty to lend into the US recovery, presumably it could have absorbed a hit to its margins to make a little more credit available to companies seeking to finance productive investment.

In fact, Federal Reserve loan officer surveys for 2016 show no restrictive trend in either residential mortgages or commercial and industrial loans, with perhaps some prudent tightening in commercial real estate, where lenders have been watchful of a bubble forming due to still very low rates. Loans might, in fact, be too easily affordable.

From 2010 through to 2016, the US economy added jobs at the rate of 2.4 million a year; the economy recovered so fully – the stock market and housing markets along with it – that the Federal Reserve became the first developed market central bank to taper quantitative easing and raise policy rates.

Yes, there has been much debate about the withdrawal of some segments from the labour market – perhaps those close to retirement age now spending their savings – but the official data suggests an economy chugging along at close to full employment.

If this feels like a bad outcome in some US communities, it is one every other developed country in the world would take in a heartbeat.

Policymakers in other developed markets agree in private conversation after conversation with Euromoney that the way the US public and private sectors pulled together after the crisis, with the forced public capital injections into banks under the Tarp programme, stringent stress tests, balance-sheet cleansing and recapture of private equity capital, is a model that fills them with envy.

As the Trump administration prepares to revoke Obama-era financial regulation, key policymakers with private-sector experience, such as Cohn and Treasury secretary nominee Steven Mnuchin, should explain whether they think this good outcome came about in spite of bank regulation or because of it.

The other false note from the chorus now proclaiming the urgent need for deregulation is the nonsensical claim that rules agreed in secretive forums by global bureaucrats in foreign lands have somehow unfairly penalized US banks and put them at a disadvantage. This looks like the all-time prize-winning alternative fact. It is the opposite of the truth.

Foreign banks are a much-reduced force in the US, while US banks dominate in many of the most keenly contested areas of international wholesale banking, notably investment banking where the US giants are devouring the breakfast, lunch and dinner of their erstwhile European rivals.

And this leads to our biggest worry of all. It looks as if what is being unleashed now is not judicious refinement to iron out bad unintended consequences of essential new rules needed to rein in a banking industry that had gone rogue in the run up to the crisis – rather it might be a reckless new era of competitive deregulation.

If the US government, encouraged by members with strong ties to the banking industry, now intends to strike home the advantage in a sector where US banks are already winning handsomely, the outcome might be both surprising and unhealthy for the global economy.

Tensions are already running high between European policymakers, regulators and banks over the potential impact from new moves to disallow internal models that reduce RWA density. This has real-world consequences in a continent where a high volume of mortgage finance depends on bank balance sheets.

In the US, an economy financed more through the capital markets, state guarantees through Fannie Mae and Freddie Mac have let banks profit from initiating mortgages and securitizing them off balance sheet, a big help to both capital and leverage ratios.

In the immediate aftermath of the financial crisis, Euromoney spoke to European policymakers who questioned whether the continent could even authorize US banks that had not signed up to Basel agreements and had spread the toxin of sub-prime liar loans through the global financial system. Common sense prevailed and US banks were not cast out. Similarly, even amid the misdeeds of banks such as HSBC in the US, licences were not revoked.

If an increasingly protectionist political ideology takes hold on both sides of the Atlantic, no one knows what the further balkanization of banking will do for the world economy, but it probably won’t be good.

And a race to the regulatory bottom in banking will all but guarantee another financial system breakdown, possibly quite soon.