Implementing President Trump’s Dodd-Frank Directive May Lead to More Bailouts, Not Fewer, in the Next Crisis

Last Friday, February 3, nearly two weeks into his term, President Trump issued a directive to revamp financial market regulation, aimed squarely at the Dodd-Frank Act of 2010 without naming it but also encompassing the financial regulatory framework as a whole. The directive presents a vague framework in the form of several “core principles” that dovetail with Congressional Republicans’ complaints that regulatory burdens have crimped banks’ ability to lend, thus reducing business expansion and job growth. Among the core principles are the prevention of taxpayer-funded bailouts and the fostering of “economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures.” 

However, Republicans’ claim flies in the face of the all-time high level of commercial and industrial lending since 2010, as pointed out by Jordan Weissman of Slate Magazine. It is possible that the true source of concern is the reduced return on equity resulting from the higher capital requirements, with historically low interest rates a contributing factor. These factors have hit banks where it hurts most – lowering profitability and depressing stock prices. If banks can return more capital to shareholders, with one estimate at $100 billion by the six largest banks due to potentially looser regulation, through buybacks and dividends, stock prices will increase. In fact, the market expected as much in its reaction to the President’s February 3 directive as bank stocks moved upward. 

One of the chief contributions of post-crisis regulation, including Dodd-Frank, was to address systemic risk through “macro-prudential” regulation. Systemic risk was at the heart of the 2007-8 financial crisis. Much of the post-crisis framework is designed to prevent taxpayer-funded bailouts by increasing the resiliency of the financial markets. Systemic risk arises, among other things, from excessive debt incurred by large banking institutions with complex, opaque corporate structures. These banking institutions typically have thousands of subsidiaries competing in a wide variety of financial markets, some of which involve high levels of risk. They can thus impose significant risk to U.S. taxpayers, who ultimately backstop the FDIC’s depository insurance fund. During the crisis, the Federal Reserve and Treasury Department bailed out several of the largest financial institutions because of the risk that their failure would lead to the collapse of the financial system. 

Banking regulators have tackled these sources of systemic risk by imposing capital surcharges on the largest financial institutions in an effort to reduce their leverage and “systemic footprint.” In addition, the Federal Reserve Board has developed annual stress tests for the largest, systemically important, banking institutions. Those banking institutions that fail these tests – and some do every year – cannot make planned dividend payments or other capital distributions to shareholders, certainly not a good omen for the performance of their stock prices. The stress test program, not a component of Dodd-Frank, has become the cornerstone of macro-prudential regulation and a flashpoint for industry opposition. 

Dodd-Frank itself addresses systemic risk in several important ways. It created a resolution mechanism for large, complex financial institutions under its Orderly Liquidation Authority (OLA) provision. The FDIC is designated as the receiver for large, interconnected financial entities whose failure poses a significant risk to the U.S.’s financial stability. These entities are also required to prepare “living wills,” or resolution plans, that map out in advance in a transparent manner to regulators how they can be wound down without undue disruption to the financial markets. Coordinating systemic risk regulation and with power to designate “systemically important financial institutions,” subjecting them to increased regulatory oversight and higher capital requirements, is the Financial Stability Oversight Council (FSOC). FSOC, chaired by the Treasury Secretary and comprised of the heads of the major financial market agencies, is charged with identifying and monitoring systemic risk. In addition, Dodd-Frank created the Office of Financial Research to provide FSOC, among other things, with research that assists FSOC in achieving this objective. 

Just how the President’s directive is likely to be implemented can only be conjectured at this point. However, it appears that the systemic risk regulatory framework is in the Administration’s and Republican Congress’s cross-hairs. The designated point person to oversee the President’s deregulatory program is Gary Cohn, formerly a senior executive of Goldman Sachs, a leading systemically important financial institution. The finance industry’s chief complaints against Dodd-Frank’s and more generally the macro-prudential systemic regulatory framework is that it is extremely costly, unpredictable due to broad agency discretion, and unnecessarily labor and capital intensive for the country’s largest financial firms. Systemic risk regulation has imposed the greatest cost on these financial behemoths. 

The discretionary and regulatory authority of FSOC, the overlord of systemic risk regulation, may be significantly reduced. Also a potential target is the costly process of preparing “living wills.” The OLA resolution process will likewise be scrutinized. But radically amending Dodd-Frank will be a long process and will likely require extensive negotiations with the opposition party. In addition, the Administration will focus on the stress testing program’s capital requirements, but will have less ability to directly affect it since it arises from independent banking agencies’ prudential safety and soundness regulation. Nevertheless, the Administration’s demonstrated capacity to jawbone and its ability to appoint sympathetic agency heads could go far in loosening banking agencies’ capital requirements. 

Pushed to the extreme, implementation of the President’s directive could reduce the resiliency of the post-crisis financial system when the next financial crisis occurs. It is hoped that the resulting regulatory framework will take a balanced approach that effectively preserves the core elements of systemic risk regulation.

Posted in