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Regulatory Reform Q&A

Regulatory Reform Q&A

  • 04.01.18
  • Markets & Investing
  • Article

Ed Mills, Washington Policy Analyst, discusses the current political environment, dominated by policy and personnel turnover in Washington, and potential headwinds for the markets.

What does regulatory reform mean for financials?

The bank deregulatory process that was anticipated fol­lowing the 2016 election is underway. Key federal banking regulators are being replaced with Trump-nominated appoin­tees, the Board of Governors at the Federal Reserve is undergoing a near total transformation, and Congress is set to make the most significant changes to the Dodd-Frank Wall Street Reform Act since its passage. This deregulatory push, combined with the tax changes enacted late last year, will likely result in increased profitability, capital return, and M&A activity for many financial services companies.

It is hard to overstate the overhaul that is occurring in the leadership of federal financial regulators. By statute, their terms are staggered to provide some continuity between administrations, but we are seeing key leader­ship changes occurring.

Perhaps no regulator has had more impact on the implemen­tation of the post-financial crisis regulatory infrastructure than the Federal Reserve. The leadership of former Chair Yellen and former Governor Tarullo saw the ‘gold plating’ of international standards and an ever- increasing series of new capital, leverage, and liquidity standards. As six of seven seats on the Board of Governors change hands under President Trump, this represents a sea change for bank regulation going forward.

We are also anticipating action on bipartisan Senate legisla­tion to increase the Systematically Important Financial Institution (SIFI) threshold on bank holding companies from $50 billion to $250 billion, among other reforms. This legisla­tion is well positioned to pass into law in the first half of 2018 and would mark the most significant changes to the Dodd- Frank Act since its passage.

Why is Congress changing these rules?

Under existing law, banks are subject to escalating levels of regulation based upon their asset size. Key thresholds include banks at $1 billion, $10 billion, $50 billion, and $250 billion in assets. These asset sizes may seem like really large numbers, but they only represent a fraction of the assets held by some of the largest banks, with the top banks well above $1 trillion in assets.

There has been concern in recent years that these thresholds are too low and have held back community and regional banks from lending to small businesses, thus slowing economic growth. There is also a belief that the regulatory framework and capital requirements put in place since the financial crisis has created a more safe and sound banking system. Now that we have entered into a more normalized economic environment, it is time to re-examine the regulatory infra­structure, especially for community and regional banks.

Responding to these concerns, a bipartisan coalition in the Senate has passed a bill to rework the regulatory framework for many community and regional banks. The bill raises the threshold for when a bank is considered ‘systemically important’ and is subject to increased regu­lations. The hope among the bill’s advocates is that these banks would see a reduction in regulatory cost, greater flexibility on business activity, increased lending, and, ultimately, a boost to economic growth.

In order to be signed into law, the bill will have to clear the House of Representatives pending potential negotiations on additional changes between the House and the Senate.

What regulatory changes do you expect in the wake of leadership transitions?

The 2016 election marked the high-water mark for finan­cial services regulation. In the coming year, we expect continued changes to the stress-testing process for the largest banks (known as CCAR), greater ability for banks to increase dividends, as well as changes to capital, leverage, and liquidity rules.

As for the Fed, we expect a multi-year deregulatory push that re-examines and removes various ‘gold plating’ of reg­ulations while providing regulatory relief for small- and medium-sized institutions. Tightening will shift away from regulation to normalization of the fed funds rate. This could represent a multi-pronged win for the banking industry: nor­malized interest rates, expanded regulatory relief, increased business activity, and lower regulatory expenses.

Another key regulator to keep an eye on is the Consumer Financial Protection Bureau, which pursued an aggressive regulatory/enforcement agenda for banks. However, the Bureau is now facing an uncertain future and is in the process of reevaluating its enforcement mechanisms. Additionally, Dodd-Frank requires review of all major rules within five years of their effective date, providing an opportunity for the Trump-appointed director to make major revisions.

With the rollback of regulations, most of which were put in place to prevent a repeat of the financial crisis, are we sowing the seeds of the next collapse?

There is little doubt that the lack of proper regulation and enforcement played a strong role in the financial crisis. The regulatory infrastructure that has been put into place since the financial crisis has undoubtedly made the banking industry safer and sounder. Fed Chairman Powell recently testified before Congress that the deregulatory bill being considered will not impact the safety and soundness of the financial industry. The ultimate test will be the enforcement of existing rules and the extent of the regulatory rollback.

In your view, what kind of political developments will have an impact on the markets?

We are keeping our eyes on actions related to trade and the mid-term elections this November. The recent announce­ment on tariffs raises concerns of a trade war, which would represent a significant headwind for the economy. As for the election, many of President Trump’s nominees have been selected and will be confirmed by November, limiting the impact on his regulatory agenda. The market may grow nervous over a potential changeover in the House and/or Senate majorities, but it could also sow optimism on the ability to see a breakthrough on other legislative priorities, especially given the need for bipartisanship and the 60 vote threshold in the Senate for legislation.

 

Read the full April 2018 Investment Strategy Quarterly
Read the full April 2018 Investment Strategy Quarterly

 

Legislative and regulatory agendas are subject to change at the discretion of leadership or as dictated by events.

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