Blog February 7, 2017

Is a Dodd-Frank Rollback Good or Bad for Bank Bondholders?

On February 3, President Trump signed an executive order focusing on core principles for regulating the U.S. financial system, which may begin the process of reconsidering or potentially undoing parts of the Dodd-Frank Act (DFA). The DFA was passed by Congress and signed into federal law by former President Barack Obama in July 2010. In this blog post, we take a credit perspective on investment-grade banks and consider the good and the bad impacts of rolling back provisions of the DFA.

The new law represented a major overhaul of the U.S. financial regulatory system as an acknowledgment of the damage caused to the real economy by the financial crisis. Among other regulations, the DFA introduced more stringent bank capital requirements and changes to derivatives, reduced proprietary trading activities, and strengthened corporate governance standards. The new stricter standards raised compliance costs for banks and required them to hold more capital, thereby creating fewer high-risk loans. Critics of DFA suggest that all loan growth has suffered; however, the data do not support such a claim. For regulated U.S. banks, the growth rate for loans and leases for all FDIC-insured institutions was 6.8 percent for 12 months ending 3Q16, or about three times the rate of GDP growth.

The Good

A watered-down DFA may allow big banks to reduce currently strong capital ratios, which would improve still subpar return-on-equity by allowing banks to make more loans and return excess capital to shareholders. An overhaul of the DFA could also cause regulatory, compliance and risk management costs for banks to decline. In recent years, big U.S. banks have hired thousands of compliance and risk management officials who have added material costs but little in the way of incremental revenues. U.S. money center bank stocks rose and bank credit spreads tightened on the executive order statement, as market participants priced in higher future earnings and shareholder rewards on prospects of bank deregulation.

The Bad

Investors should also consider longer-term, negative credit impacts of rolling back the DFA, including the potential weakening of bank capital and regulatory frameworks. Historically, weak or declining bank capital ratios have caused bank failures to increase (see graph).

Banking regulators (e.g. the Federal Reserve, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency and others) played important roles in implementing the DFA, raising minimum capital requirements and introducing more sophisticated capital measures and stress tests. Should the DFA be rolled back and regulatory frameworks weakened, banks could undo some of their progress toward stronger capital positions, which could negatively impact bank credit profiles and bond spreads.

Additionally, larger U.S. banks have shuttered proprietary trading desks in response to the Volcker Rule, a component of the DFA. The DFA led to a material reduction in illiquid, Level 3 assets,[3] which proved to be problematic for large banks during and immediately after the financial crisis. Balance sheets are more liquid and transparent today, and rolling back regulations could increase speculative trading, risk-taking and illiquid asset accumulation on bank balance sheets.

Our Take

So, are moves to dismantle or retool the DFA good or bad for bank bondholders? In our view, the answer lies largely in the time frame considered and is mindful of the “short-termism” discussed in the article Incentivizing Corporate Long-Termism in our 4Q16 Sustainability Newsletter. Cutting down the DFA may support near-term earnings results for some U.S. banks. However, over the longer term, a more lightly regulated U.S. banking system would increase credit risk for bondholders by enabling big banks to re-leverage their balance sheets and take greater trading and lending risks.

Large U.S. banks are presently playing from a position of capital strength. This has driven market share gains in capital-intensive trading and investment banking at U.S. banks, primarily at the expense of capital-constrained European banks. U.S. bank CEOs and regulators must remember the consequences of a combination of high leverage and weak regulatory oversight.

Since the financial crisis, U.S. banks have worked hard to rebuild their financial, political and human capital and make reparations for the loss of public trust in large financial institutions. We should be cautious in undoing regulatory frameworks that have prompted improvements in bank credit profiles and spurred U.S. banks to be a source of stability for the economy.

[1] See Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 157, Fair Value Measurements.