The credit cycle has been extended by central bank policies that enable high corporate borrowing at very low interest rates.
The Economic Growth, Regulatory Relief, and Consumer Protection Act (S.2155) was signed into law May 24. The Act rolls back provisions of the Dodd-Frank Act (DFA), which was put into place following the financial crisis. Banks have improved their capital positions over the past decade partly due to the more stringent regulatory standards imposed by the DFA. A rollback had been widely expected given the current administration’s efforts to deregulate the banking industry.
This post updates our February piece Is a Dodd-Frank Rollback Good or Bad for Bank Bondholders?, offering our thoughts on the bank regulatory environment under S.2155 and providing a “now what” for bank bondholders under the new laws.
The New Legislation Retains Some Important DFA Provisions
In our view, several provisions in S.2155 are positive for bank credit.
- It directs the U.S. Treasury to report on the risks of cyberthreats to financial institutions and capital markets. Given the reputational and financial risks involved in cyberattacks, an increased focus on cybersecurity by the Treasury and the major banks, and greater transparency in this area, are credit-positives.
- The Volcker Rule, a component of the DFA, remains in place for U.S. money center banks. The Volcker rule prohibited banks from engaging in proprietary trading, subject to exceptions, and restricted other high-risk activities. The rule’s persistence may reduce the risk of speculative, ill-timed trading bets and limit the growth of less-liquid Level 31 assets at the largest U.S. banks.
- Enhanced prudential standards and mandatory stress tests will still apply to bank holding companies with assets greater than $250 billion. This threshold covers all eight of the U.S. global systemically important banks (G-SIBs).2 The Federal Reserve Board also has discretion in determining whether a bank with assets greater than $100 billion must be subject to such standards. This indicates that supervision for the largest U.S. banks and the major bond issuers should remain robust, which is a credit-positive for the sector.
However, Some Parts of the Rollback Are Credit-Negative
S.2155 was put in place for several reasons, such as improving consumer access to mortgage credit; providing regulatory relief particularly for small banks; tailoring regulations for certain bank holding companies; and encouraging capital formation. In seeking these goals, S.2155 has brought about some potential negatives to bank credit fundamentals.
- It allows smaller banks to forgo certain ability-to-pay requirements regarding residential mortgage loans. Notably, these ability-to-pay requirements are only waived if the loan meets certain criteria. Still, ability-to-pay is a critical aspect of underwriting and this change is credit-negative, in our view.
- It exempts banks with assets of $10 billion or less from certain escrow requirements for residential mortgages. Escrow requirements are in place to ensure that property tax and insurance premiums are paid. Waiving this requirement presents credit risks to the banking system.
- It exempts smaller banks from the Volcker Rule. While small banks are not typically active in this area, the savings and loan crisis of the 1980s revealed substantial risks in bank investment portfolios.
- It allows an 18-month examination cycle for certain smaller banks, extended from the current 12-month cycle. While this change may reduce compliance costs for smaller banks, it could also result in less frequent oversight of risks building in the banking system.
- It provides capital relief related to commercial real estate (CRE) lending (excluding construction loans). Given the significant rise in CRE delinquencies during the financial crisis and risks related to CRE loans,3 this loosening of regulation is a credit-negative, in our view.
Rollback Presents Risks, but with Mitigating Factors
Our overall view on the Dodd-Frank rollback is unchanged. Reduced compliance costs, looser underwriting standards and increased regulatory relief may support near-term earnings for U.S. banks, particularly smaller regional banks and community lenders. However, over the long term, a more lightly regulated U.S. banking system may increase risks to the broader financial system, and by extension, to bank creditors. The U.S. banking system is highly interconnected through correspondent banking, syndicated lending, counterparty credit and derivatives trading. Regulatory relief in one area may have unintended knock-on effects in others.
U.S. bank profitability is currently strong, and the industry reported an 11 percent return on equity in 1Q18 (Figure 1). Still, we have concerns about the timing of the additional regulatory relief. After a protracted nine years of economic expansion in the U.S., and with mounting evidence that consumers are beginning to fall behind on auto loans and credit card payments, we see risks with a rollback at this time, as it may encourage banks to expand credit growth or return more capital to shareholders when the cycle is late-stage. That said, regulatory relief provided by S.2155 is more directly applicable to smaller banks, and de minimis for G-SIBs, which mitigates the negative credit impacts.
 See Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 157, Fair Value Measurements.
 The Basel Committee on Banking Supervision assesses and identifies global systematically important banks under a specific methodology. See http://www.fsb.org/wp-content/uploads/2016-list-of-global-systemically-important-banks-G-SIBs.pdf
 Congressional Oversight Panel, February 10, 2010, see https://www.gpo.gov/fdsys/pkg/CPRT-111JPRT54785/pdf/CPRT-111JPRT54785.pdf.
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