Gutting Dodd-Frank Will Sow the Seeds of the Next Financial Crisis

President-elect Donald Trump had barely finished winning the 2016 presidential election before financial regulation foes began salivating at the prospect of tearing up the Dodd-Frank Act, President Barack Obama’s signature financial reform law.

It has been eight years since the financial crisis. While calculating the cost of the 2008 crisis with perfect precision is impossible, studies conducted by the non-partisan Government Accountability Office and the Dallas Federal Reserve Bank estimate the cost at about $6 trillion to $14 trillion, meaning it cost each American about $19,000-$45,000.

Politicians and lobbyists in Washington are treating the elimination of financial protections for Americans like a competitive sport. The story they often tell is that bank regulations have led to a very slow recovery. Another false narrative is that bank regulation has led to reduced lending.

The reality is that banks reduced lending during the crisis and into 2009, precisely because a lack of due diligence led them to make loans and investments in bonds, such as securitizations, that defaulted in 2007-2008. In the aftermath, banks had to increase their capital to sustain unexpected losses. Also, fewer Americans were demanding loans, since they were either unemployed or uncertain about the direction of the U.S. economy.

Eight years later, 2016 data from the Federal Deposit Insurance Corporation Quarterly show that loan and lease balances increased 6.9 percent over the 12 months ended March 31, the highest growth rate in nearly eight years, and unused credit lines also increased.

Importantly, the FDIC reported this summer that the number of banks on its ‘Problem List’ fell from 165 to 147, the lowest in eight years, while total assets of problem banks fell from $30.9 billion to $29 billion. A time when loan approvals to credit-worthy individuals and institutions are growing and the number of problem banks is falling is not the time to reduce regulations: that would allow big banks yet again to neglect due diligence standards in lending to individuals and companies.

Analysts and journalists are trying to read the tea leaves to predict the future of banking regulation after the U.S. presidential election. Because President-elect Trump has been vague — to say the least — on banking regulation, the best guide to figure out what Republicans, who will now control both the House and Senate, might propose is the Financial CHOICE Act.

This is a Republican proposal to reform the financial regulatory system. This proposal was released on June 23.

The Financial CHOICE Act would enable banks to exchange a higher leverage ratio for exemptions from other Dodd-Frank requirements. Banks would need to maintain a leverage ratio of at least 10 percent. They would also need an international banking rating that assesses how risk exposures can affect banks — known as CAMELS (capital adequacy, asset quality, management capability, earnings, liquidity and sensitivity) — of 1 or 2, to be exempted from certain rules under Dodd-Frank, including Basel III and liquidity and prudential standards.

The requirement of a 10 percent leverage ratio for large banks could be a good idea if it means that banks would be compelled to have enough common equity to cover the risk engendered both by on- and off-balance sheet items such as loans, securities and derivatives. Yet, under current U.S. Basel capital requirements, even large, complex banks are required to have a much lower leverage ratio. Bank lobbyists have fought tooth and nail against the current U.S. leverage ratio requirements and will fight even harder against a 10 percent leverage ratio, which would make it harder for banks to transact in risky securities and derivatives that are typically more profitable than conservative investments.

Giving banks the option not to implement liquidity standards, comprehensive capital adequacy reviews, stress tests and writing bank recovery and resolution plans is a terrible idea.

The reason that banks are now required to conduct capital adequacy reviews and stress tests is precisely because during the crisis, banks were unaware of the true quality of their assets and were insufficiently capitalized to sustain unexpected losses. Recovery and resolution plans — or living wills — are also an important way to compel banks to better understand the risks in their, often numerous, legal entities and allow bank regulators to see how a bank would have to be resolved if it failed.

Senators Sherrod Brown, Charles Schumer and Elizabeth Warren have all promised to fight attempts to weaken Dodd-Frank.

Like any legislation, Dodd-Frank is imperfect. Yet, what the ‘dismantle Dodd-Frank’ crowd is proposing is very likely sowing the seeds for another financial crisis.

Originally Appeared in Bloomberg Brief

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