TREND WATCH: What’s Happening? The pieces are in place for Republicans to finally dismantle the Dodd-Frank Act. Critics of the legislation have long argued that it is bad for the economy—to wit, that it is crippling banks, constricting overall credit, blocking loans to small business, and starving markets of liquidity.
Our Take: Few of these arguments are terribly persuasive. Even fewer will fetch much public sympathy. Accordingly, critics may be disappointed by how little energy either the Trump White House or Congress puts into a wholesale Dodd-Frank repeal. The Republicans have three ways to kill Dodd-Frank: Pass legislation, undergo the budget reconciliation process, or simply fail to execute bits and pieces of the law—the latter being the easiest and most Trump-like option. In short, the repeal is likely to underwhelm.
Is this the beginning of the end for Dodd-Frank?
In February, President Trump fired the first shots against the Obama-era financial legislation when he issued an executive order calling for a review of the laws and regulations that govern the U.S. financial system. More recently, during a town hall-style meeting with 50 CEOs (Trump’s unique twist on populism), the president indicated that he plans to give Dodd-Frank “a very major haircut.”
But first, some background on the law. In 2010, President Barack Obama signed Dodd-Frank, which aimed to curb the risky behavior by financial firms that triggered the Great Recession. It is an enormously complex piece of legislation, essentially creating a vast new web of interwoven agencies, regulations, protocols, and disclosure requirements intended to make the financial industry more responsible. It focuses mostly on bank holding companies, but also brings nonbanks—including insurance companies and investment advisors and even rating agencies—into its regulatory skein.
Importantly, Dodd-Frank created the Financial Stability Oversight Council (FSOC), which—assisted by the Office of Financial Research (OFC)—monitors the financial stability of major firms. It runs stress tests, scrutinizes derivatives trading, weighs assets by risk class, and so on. If a bank is deemed “too big to fail,” the FSOC has the power to break it up and the Federal Reserve can hike its reserve requirements.
Dodd-Frank also created the Consumer Financial Protection Bureau (CFPB), which works with regulators in large banks to stop practices that defraud consumers, such as misleading advertising. The CFPB oversees credit reporting agencies, credit and debit cards, payday loans, and consumer loans as well.
Another key component is the Volcker Rule, which prohibits banks from owning, investing, or sponsoring hedge funds, private equity funds, or any proprietary trading options for their own profit. This rule effectively forces banks to separate their commercial banking activities from their investment activities.
WHAT DODD-FRANK CRITICS ARE SAYING
Dodd-Frank has no shortage of critics, who have been wielding several distinct arguments against the legislation. None of these arguments are slam dunks, to say the least.
Argument #1: Dodd-Frank is crippling the banking industry. Critics argue that the hallmarks of Dodd-Frank—like the CEO pay ratio rule, mandatory “stress tests,” the fiduciary rule, and the CFPB—are so costly and cumbersome that they are threatening the survival of banks as an institution. The word "disaster" (echoed by Trump himself) is often used in banking newsletters to describe its effects.
Really? Yes, to be sure, banks have been hit hard over the past decade. Their earnings have gone down and their prices have plummeted. But these problems are rooted in far more than unfriendly legislation. The subprime housing crisis hammered big banks, while aggressive quantitative easing over the ensuing years flattened the yield curve, thereby squeezing banks' net interest margins.
Over the last year, moreover, banks’ fortunes have turned around—and not just because of the prospect of a Dodd-Frank repeal, but also because of an improving economy and a steepening yield curve. Total market returns on the largest U.S. banks have more than quintupled since their Great Recession nadir and are now back near their 2007 peak.
As for the financial sector as a whole, can anyone seriously be worried that it isn't big enough? As of Q4 2016, financial services including insurance accounted for 5.2% of GDP, near its all-time historical high and vastly higher than in the early postwar era when somehow the U.S. economy managed to eke by. True, the value-added of U.S. financial firms has been boosted in recent decades by rising earnings abroad. On the other hand, proper inflation accounting would reduce the banks' GDP share from the mid-1960s to the mid-1990s. In any case, the growing "financialization" of the U.S. economy may itself pose a threat to competive markets and productivity growth.
Critics lean on data showing that since Dodd-Frank was enacted, one in five U.S. banks has disappeared and virtually no new banks have formed to replace them. Yet they rarely highlight the fact that most of these disappearing banks were community banks and other small banks, which were forced to sell off assets to comply with the Volcker Rule. Compliance costs have also taken a toll on small banks. According to former Chairman of the Community Bankers Council Bill Grant, “The cost of regulatory compliance as a share of operating expenses is two-and-a-half times greater for small banks than for large banks.”
A much better case against Dodd-Frank is not that it's hurting banks generally—but that it is differentially favoring large banks (who can lobby and handle the compliance costs) over small banks. Yet most of the Dodd-Frank regulations on the political chopping block—like the CEO pay ratio rule and stress tests—affect large banks, not small banks. Small banks would like to scrap the Collins Amendment, which prevents regulators from lowering capital requirements for different-sized banks, but Dodd-Frank critics don’t show much interest in this issue.
Argument #2: Dodd-Frank stifles lending. A broader argument focuses not on what Dodd-Frank does to the profitability of banks, large or small (after all, how many voters are going to feel sorry for bank owners?), but rather on how Dodd-Frank keeps banks from lending, which is their primary function after all.
This narrative is predicated on the premise that corporate America is having trouble borrowing. Yet this is manifestly not the case. Clearly, post-GFC America is not having any trouble re-leveraging itself. Nonfinancial corporate credit has been rising as a share of GDP for years, recently hitting 72.8%—which is the highest level ever recorded, higher even than the previous peak of 72.7% registered in Q3 2008. Again, one might worry that all this borrowing (much of it for stock buybacks) may actually be excessive.
Everyone knows that U.S. households deleveraged sharply after the bursting of the mortgage bubble. But household credit is still higher as a share of GDP than at any point before 2003. Moreover, this ratio has recently plateaued—and actually began rising again starting in Q2 of 2016, buoyed especially by non-home consumer borrowing. Maybe one could make the argument that many households who need credit can't get it—but repealing Dodd-Frank to help the ordinary consumer is not exactly a rallying cry that anyone expects to catch fire.
Argument #3: Dodd-Frank penalizes small businesses. Critics are wielding another argument in their efforts to move the public needle: that Dodd-Frank hurts small businesses. Speaking of his business owner friends, Trump himself says, "They just can't get any money because the banks just won't let them borrow it because of the rules and regulations in Dodd-Frank."
This view draws upon the findings of Goldman Sachs’ The Two-Speed Economy report. Goldman observes that large corporations have performed better than small ones (defined as those with less than 500 employees) since the last recession, as measured by revenue, employment, and wage growth. And it attributes that performance gap to the availability of financing. Not only have increased capital requirements and other new regulations reduced the availability of credit for small businesses, the critics claim, but these regulations have also raised fixed costs. The critics point to a decline in the number of small businesses, the continued employment lag among small firms compared to large firms, and the decline of sole proprietorships as a share of the labor force as evidence that U.S. small businesses are struggling.
But this argument is mainly circumstantial. Small firms may very well be struggling—but it’s hard to demonstrate that borrowing is a big problem for them. In fact, a January National Federation of Independent Business (NFIB) survey found that only 2% of small-business owners said finance or access to credit was their most pressing problem—matching the lowest level in the history of the survey. And according to the NFIB’s annual survey, obtaining long-term and short-term business loans ranked as the 69th and 70th (out of 75) most pressing problem for small businesses, respectively, in 2016.
Obviously, subpar small business growth could be blamed on any number of factors outside of credit availability—from increased market concentration to the declining business startup rate of today’s young adults. As we have discussed elsewhere (see: “Shhh! The Markets Are Concentrating”), a growing number of industries have become dominated by a declining number of firms. This is indicative of a larger, very real problem in America today: declining business dynamism, measured by rates of new business formation and worker churn.
But nobody who studies this issue regards it as mainly—or even significantly—associated with banking.
Argument #4: Dodd-Frank hurts markets. A final argument used by some critics hinges on one Dodd-Frank cornerstone in particular: the Volcker Rule. Larry Summers, Stephen Schwarzman, and Jamie Dimon all say that easing up on the rule would improve overall market liquidity—since proprietary trading allows banks to perform numerous market-making functions by buying when prices are low and selling when prices are high.
This case against the Volcker Rule seemed a bit more plausible a year ago, when the VIX was high, than today, when the VIX is low and when "complacency indexes" are breaking all records. Indeed, some economists believe that prop trading by institutions that are "too big to fail" represents an implicit public subsidy of low volatility. It is, in other words, a policy that leads to the overpricing of traded securities.
In any event, the Volcker Rule will probably survive any likely Dodd-Frank repeal because it has many supporters even among some of Dodd-Frank's staunchest critics. Both Treasury Secretary Mnuchin and NEC Director Gary Cohn recently came out in favor re-instituting some form of the Glass-Steagall Act, which may as well be the Volcker Rule reincarnated.
WHAT’S NEXT FOR REPUBLICANS?
Whatever the motive, it’s clear that the GOP wants and intends to dismantle much of Dodd-Frank. What are its options?
Pass new legislation. If you thought “repeal and replace” applied only to health care, think again: Republican Representative Jeb Hensarling has already introduced a Dodd-Frank replacement called the Financial CHOICE Act. This legislation would repeal the Volcker Rule and the Durbin Amendment (the latter sets a limit on debit card transaction fees for retailers) and would create a more flexible regulatory structure.
But Hensarling’s bill faces three major roadblocks. First, his more libertarian, level-playing-field approach doesn’t appeal to the big banks. Second, the bill may not be well-received in the Senate. And third, any Senate bill would require Democratic support to attain 60 votes. (Hensarling said last month that he’s getting ready to reintroduce his bill with a few tweaks.)
An alternative replacement has been floated by the conservative Heritage Foundation, which praises many tenets of Hensarling’s bill but proposes additional measures such as eliminating stress tests as well as raising and simplifying the leverage ratio.
Cut vital Dodd-Frank funding. Republicans have another trick up their sleeves: the budget reconciliation process. If the GOP can prove that Dodd-Frank has a direct impact on federal spending, they can dismantle parts of Dodd-Frank with only 51 Senate votes. This would enable Republicans to cut funding from their least favorite Dodd-Frank tenet: the CFPB.
Why do Republicans hate the CFPB? Representative Hensarling argues that it’s the least accountable agency in all of Washington.” Senator Ted Cruz calls it “a runaway agency.” And Republicans make a solid point—the CFPB is expansive and has little oversight. By design, the CFPB acts as a “cop on the beat” to investigate problems and casts a wider net than other regulatory agencies to do the job.
Allow Dodd-Frank to fall into neglect. Perhaps the most likely option, however, doesn’t require any congressional action. With President Trump at the helm, many Wall Street executives are hoping that new leaders at the SEC and the Commodities Futures Trading Commission will simply develop regulatory apathy and look the other way when it comes to violations of the Volcker rule and other Dodd-Frank regulations—a political shortcut Wall Street is sure to cash in on.
GOING FORWARD
Overall, nearly all Republicans can agree on what they don’t like about Dodd-Frank: It empowers an administrative state with too many committees, too much complexity (the legislation spans 2,300 pages), and too much regulatory discretion.
Their opposition, however, falls into two distinct camps. The libertarian wing is made up of principled conservatives who want an absolutely level playing field applied to all businesses, and who would let the chips fall where they may. Individuals like Hensarling no doubt desire fewer regulations of banks yet also fewer subsidies to banks (for example, the implicit bailout promise for “too big to fail” firms).
Meanwhile, the growing populist wing of the party has a more paternalistic approach and wants to unfetter Wall Street so it can “take care of” consumers. This crowd is not as bothered by the CFPB as the libertarian wing. And it is less concerned about whether markets work perfectly in all the fine details than whether "big bankers" are publicly (though perhaps only symbolically) stripped of their privileges.
For his part, President Trump generally implies that he belongs to the latter camp. During his presidential campaign, he railed against Wall Street almost as zealously as Bernie Sanders—and more than once spoke favorably of going back to Glass-Steagall. He styles himself a populist in the tradition of Andrew Jackson, a president whose loathing of big banks was legendary. It is difficult to imagine Trump championing a large piece of legislation setting big banks free from Dodd-Frank and publicly rallying his supporters to get it through Congress.
Then again, there is the other Donald Trump, who has spent his first three months in office cozying up to Wall Street executives—including alumni from the very banks that would love to see Dodd-Frank dismantled. In February, he hosted his first Strategic and Policy Forum—inviting chairmen and CEOs from General Electric, IBM, Boeing, Walmart, Walt Disney Company, and General Motors to the White House. Trump has already tapped several Goldman Sachs alumni for key positions in his administration—including James Donovan, Gary Cohn, Steven Mnuchin, Jay Clayton, Anthony Scaramucci, Dina Powell, and Steve Bannon. He’s also brought Blackstone Group’s Steve Schwarzman, BlackRock’s Larry Fink, and JPMorgan Chase’s Jamie Dimon either into his Cabinet or his inner circle in an advisory capacity.
What does this contradiction mean? It increases the odds that Trump, wanting to please both camps, won't even attempt to design some great legislative solution. The easier path, simply failing to enforce certain provisions of Dodd-Frank on an ad hoc basic, seems far more likely.
