Have we been duped by those who seek to protect us… again?

Have we been duped by those who seek to protect us… again?

Post financial crisis, regulators and governments scrambled to introduce various legislation to prevent systemic issues arising again.

The Dodd Frank Wall Street Reform and Consumer Protection Act was introduced after the financial crisis to prevent excessive and dangerous banking practices that partly caused the 2008 meltdown, as well as the requirement of taxpayers to bail out large investment banks and other institutions.

There were murmurings when Trump was elected that he would look to repeal the act to the glee of his Wall Street pals.

Nothing came of it at the time, but now those murmurings are back again…

I won’t go through all of the terms of Dodd Frank because there are so many, and quite frankly, I don’t have the relevant experience to comment on some parts of it. The parts I do understand, however, I will do my best to explain and evaluate.

In short, Dodd Frank is there to increase moral hazard on banks to protect the end consumer.

Moral Hazard – lack of incentive to guard against risk where one is protected from its consequences, e.g. by insurance.

Banks were deemed too big to fail. They knew that the taxpayer would have to bail them out.

Dodd Frank’s introduction makes them more susceptible (in theory, but I’ll come onto this later) to accountability. The introduction of The Financial Stability Oversight Council and Orderly Liquidation Authority and Consumer Financial Protection Bureau:

1) Force banks to increase capital base (increase liquidity) if they are deemed to hold too much systemic risk and also break up banks for the same reason (ha, as if that would ever happen) and

2) The CFPB prevents mortgage brokers from earning high commissions via predatory practices (giving out subprime mortgages like they’re sweets) whereby they earn higher interest payments but the assets end up having a higher default risk.

What could Trump possibly benefit from by deregulating these areas? Well, he has quite a few ex Goldman executives around him.

Trump is a believer in trickle-down economics, whereby the rich who provide jobs will eventually have their wealth trickle down to the workforce that they have created jobs for.

But this has been proven not to work – look at the increasing disparity between executive pay and lowest paid workers in the majority of large firms.

The issue here is that repealing Dodd-Frank may mean rejecting the accountability measure that should be placed on banks when dealing with a product such as mortgage backed securities.

Everyone who owns a home or is renting from a landlord can be affected when they are traded and when they fail – or when the banking system elsewhere fails.

I think there has been too much emphasis placed on Dodd-Frank being the main development in banking regulation and process, however.

Basel III, another regulatory framework requiring banks to hold specific capital requirements, has been a far greater and more far reaching introduction.

It’s been introduced in both Europe and the US.

Whether you want to attribute the following to Dodd-Frank or Basel III is negligible, because all that is really apparent about the following quote by Mark Calabria, director of financial studies at the Cato institute, is that systematically, the risk to the financial system is essentially the same if not subjectively worse than 2008:

Just how much has bank capital increased since the passage of Dodd-Frank? It all depends on what you mean by capital. 

According to the FDIC, at the end of 2015, commercial banks had “total equity capital” of $1.8 trillion.

This is certainly higher than the $1.5 trillion that existed at the time of Dodd-Frank’s passage. But bank assets also increased. What matters is the ratio of bank capital to total bank assets. At the passage of Dodd-Frank that ratio was 11.1. At year-end 2015, it was 11.2.

Some apparent increases in bank capital relative to risk-weighted assets are due to the fact that banks have massively shifted into low risk-weight assets.

Under a system of risk weighted capital, the required capital is a function of the target capital level times the risk weight of the volume of the asset.
For example whole mortgages have historically had a risk weight of 50%.

So if one holds $100 million in whole mortgages and the target capital is 8%, then actual capital is not $8 million but rather $4 million (8 x 0.5). 

Needless to say, the risk weights have come under considerable scrutiny, especially since assets like Greek government debt were given risk weights of zero.

Since Dodd-Frank, commercial banks have more than doubled their holdings of U.S. Treasuries, which require zero capital. 

Banks have also increased their holdings of mortgage-backed securities and municipal debt, which also have low risk weights. The point is that banks haven’t really raised lots of new capital as much as they’ve gamed the risk-weights to appear to have more capital.

So the argument that repealing Dodd-Frank based on reducing systematic risk actually vanishes pretty quickly, since nothing has really changed when looking at the books.

I would argue it has actually been made worse, except the introduction of Dodd Frank has simply allowed a veneer of respectability and accountability to be placed onto bank books.

If this is the case, then Dodd Frank is merely protecting consumers via introducing some moral hazard via the offices that have been set up to supervise bank activity.

But if everything goes bottoms up again, they won’t really matter, will they? 

I would argue that the necessity to prevent practices such as being able to buy naked credit default swaps on failing assets while selling that failing asset to someone else (imagine being able to buy insurance on your neighbor’s house, setting fire to it, then collecting the insurance money – Goldman were doing essentially that with collateralized debt obligations), which only Europe have done, is necessary.

Increasing pre and post trade transparency and reporting on bank risk is vital to be able to monitor systemic risk as well.

But let’s think of this. Has Dodd-Frank/Basel III prevented Deutsche Bank or Santander from repeatedly failing stress tests in the US? Nope.

I think that repealing Dodd Frank won’t make much of a difference to systematic risk at all by looking at the last paragraph of the quote.

So Trump maybe unhinged, but this isn’t really an outcome which is going to absolutely wreck the world as media may have you believe.

But don’t get me wrong, the fixing of the books is shocking – especially when you consider the fact that banks are facing crises similar to 2008 except in different assets…

…and the dreaded collateralized debt obligations making a return…

All the while we still haven’t faced a global interest rate rise that will affect instrument financing and liquidity…

I could go on but that would direct from the overall takeaway from this piece…

The banks are in no different shape now than they were in 2007/08.

And that is something everyone should worry about.

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