The U.S. Economy in a (Post?) Dodd-Frank Nation

We have reached a reflection point in the history of financial regulation. The Financial Choice Act (FCA) passed the GOP-led House Thursday, June 8, along party lines, while the Comey testimony engulfed much of Washington, D.C., and garnered the attention of the mainstream media. The bill didn’t drive ratings like the appetizing notion of a potential Trump and Comey showdown, but its derivatives could very well have more long-term meaning.

The bill currently has a dim future in the filibuster anxious Senate, with Jaret Seiburg, an analyst at Cowen & Co, stating that “we continue to see no path forward for this legislation in the senate.” The Act’s symbolic ideology; however, demands a deeper inquiry into the objectives of its supporters and the possibility of a dramatically revised version eventually emerging out of the senate.

So what exactly do we know? We know the FCA strives to undo much of Obama’s signature financial regulations in the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA). The author, House Financial Services Committee Chairman Jeb Hensarling (R-Texas) has confirmed as much, quoted as telling reporters “Dodd-Frank represents the greatest regulatory burden on our economy, more so than all the other Obama-era regulations combined. There is a better way: economic growth for all; bank bailouts for none.” The latter claim, bank bailouts for none, requires a level of discourse on economic theory far beyond the scope of this review, but the former (economic growth for all) is an intriguing assertion.

Indisputably, there are many companies who favor at least a partial repeal of the Dodd Frank Act. Emilio Gonzalez, CEO of BT Investment Management, discussed the Financial Choice Act on its second quarter earnings call on May 10, “The U.S. in many respects is going against the trend in terms of regulation. That's encouraging.” On Thursday, June 8 Metlife CEO Steven A. Kandarian had this to say in regards to the passage of the Financial Choice Act, “Regulating companies appropriately ­– not excessively – is critical to fueling robust economic growth and creating jobs,” but does loosening (or tightening) financial regulation actually lead to a material change in economic growth? We blast off, Elon Musk style, for answers.

The regulatory quantity of the DFA and the FCA ensure that evaluating all of the financial regulations contained within the bills, both in implementation and repeal, would be unnecessary to derive a general conclusion about their impact on economic growth. For the purposes of this assessment we evaluate two areas discussed in the bills: capital requirements and the Volcker rule.

Both the Dodd Frank Act and the Financial Choice Act have capital requirements, though the calculation to reach those ratios vary in both process and severity. In an article written in December of 2014, Stephen Cecchetti of the Centre for Economic Policy Research concluded: “the predictions that higher capital requirements would drive up interest margins and reduce credit volumes are very clearly at odds with the evidence of smaller spreads and increased lending. Insofar as there was any macroeconomic impact at all, it appears to have been inconsequential. Instead, especially in a weak economy, it is high levels of initial bank capital that lead to healthy lending.” Cecchetti’s conclusion is consistent with other studies we have seen. That is not to say that regulatory policy requiring set capital levels or leverage ratios never leads to decreased short-term profitability. The very nature of holding more capital (i.e.lending less) inherently suggests lower periodic returns. However, it merely implies the long-term data reflects a net positive, or at worst income neutral, when factoring in the mitigating effects of an economic slow-down or recession.

The impact of the Volcker Rule, which strives to ban portions of proprietary trading i.e. where banks can use their own funds to speculate, on economic growth and profitability is less transparent, and the “independent” studies on the topic are generally funded by political biased organization. Here is what’s (relatively) clear: 

  • Proprietary trading wasn’t directly responsible for the most recent crisis, but it didn’t help

  • The Volcker Rule is incredibly complex and expensive to the banking industry, perhaps as much as 4.3 billion dollars.

  • The existence of proprietary trading increases the possibility of individual bank failures, and that as a whole raises the level of a systemic crisis.

The rule would likely shrink economic growth in the financial sector. However, questions still persists. To what degree would it hinder financial profitability? How much stability does the rule add to the financial sector as a whole? Can the rule be modified to reduce compliance costs while still maintaining its current level of effectiveness? The limited timeframe by which we have to evaluate the rule makes those questions seemingly unanswerable. However, the simple passage of time alone will help uncover the effect of a potential post Dodd-Frank nation.