Risk Management: Another look at Financial Regulatory Reform.

“What are the strengths and weaknesses of the different plans for financial regulatory reform?”

By Tristan Baylor

On Friday, February 3rd, President Trump signed an executive order giving the U.S. Treasury, headed by Sec. of the Treasury Steve Mnuchin, the authority to restructure key provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly referred to as Dodd-Frank. President Obama signed this act into federal law in 2010, hoping that stricter regulations and newly created oversight councils would prevent the kind of economic disaster the U.S. faced in 2007-2010. Although the Act intended to limit risk taking by banks, many economists and business leaders see it as regulatory overreach that has worked to make the U.S. financial industry more uncompetitive, complex, and entrenched with bureaucracy. Two GOP-crafted plans have been presented as alternatives to Dodd-Frank; the Financial CHOICE Act and the Minneapolis Plan. This article aims to interpret the strengths and weaknesses of both plans.

Views from the Right

As a path forward, the chairman of the House Financial Services Committee, Rep. Jeb Hensarling, introduced a plan in 2016 called the Financial CHOICE Act. The CHOICE Act would make a significant, market-based reform to the U.S. financial regulatory landscape. The Act’s main concern is how banks fund themselves with capital. By creating incentives for large banks to fund themselves with more capital and less debt, losses are borne by shareholders. One of the key complications in the 2007 market crash was the interconnectivity of financial institutions: when Bear Stearns and Lehman Brothers began to fail, it rippled not only into the other large investment banks, but also to insurance companies like AIG as well.

A rough framework for how the Act deals with measures of capital adequacy is the following: banks would fund themselves with more than 10 percent equity relative to the value of their assets. However, this would not be a regulatory requirement, which is the key market-based aspect of the bill. Instead, banks can choose to operate with less capital and deal with the complexities of Dodd-Frank regulations, such as those limiting mergers or acquisitions of assets or control, and certain Dodd-Frank capital regulations. However, they can also choose to operate with more capital, exempting them from the aforementioned Dodd-Frank regulations along with others. Other provisions include maintaining a 10 percent leverage ratio throughout a position or trade.

The Consequences and Criticisms

This would more easily allow new financial institutions to enter into and compete in the market, since smaller institutions could assume more risk in order to compensate for their smaller total assets-under-management. As the landscape currently stands, compliance costs associated with regulations eat up such a large amount of budget that only large, established institutions can survive. Uncompetitive markets can lead to complacency towards customers from the large institutions. Criticism of the plan, largely from Democrats, centers on the relaxation of leverage requirements, since many see historic, more relaxed regulatory requirements as a root cause of the 2008 financial crisis. Furthermore, the plan still relies on leverage ratios, the criticism of which is addressed in my discussion of the Minneapolis Plan.

Minimizing Risk and Raising the Bar on Requirements

A rival to this plan comes from Federal Reserve of Minneapolis President Neel Kashkari, dubbed the Minneapolis Plan. Kashkari’s plan would have banks with over 250 billion USD in assets hold common equity equivalent to 23.5 percent of risk-weighted assets. This is a very important provision, as it would replace the current system that relies on leverage ratios. Many economists, like John Cochrane of the Hoover Institute, see the leverage ratio as being inaccurate because it doesn’t account for risk. For example, if the leverage ratio is 10%, then a bank must have 10 USD of equity to take 90 USD of a consumer’s money to buy 100 USD worth of reserves at the Federal Reserve. Federal Reserve bonds would be a completely riskless investment, since historically the U.S. has never defaulted on a bond. This can give banks an incentive to invest in riskier assets or securities; a 10 USD call option would require 1 USD of equity, but be much riskier. Call options buy the right, but not the obligation, to purchase an asset at a future date for an agreed upon price. If the market value of the asset is lower than the contract price on the future date, the buyer of that option loses all 10 USD. In addition, this plan calls for an annual increase in the equity percentage of risk-weighted assets requirement up to a cap of 38% if a bank is unable to meet an annual certification requirement regarding the systemic risk it poses to the financial system.

Trump, and the Road Ahead…

Both of these plans work towards making financial regulation less complex, and would solve what the creators of the respective plans see as the outstanding issue of “Too Big to Fail” banks – banks whose failure would impact the overall financial system through a rippling effect. Right now Rep. Hensarling’s plan is receiving more consideration, especially with his fellow GOP Congressmen and women. Furthermore, President Trump has criticized the Federal Reserve in the past, of which Neel Kashkari is a board member. It is clear that there is strong sentiment toward regulatory reform in the current environment, however, the direction this will take is unclear in a seemingly unpredictable Trump administration.

 

Sources

Cochrane, J. (2017, February 3). A way to fight bank runs-and regulatory complexity. Retrieved from http://review.chicagobooth.edu/public-policy/2017/article/way-fight-bank-runs%E2%80%94and-regulatory-complexity

Hensarling, J. (n.d.). The Financial CHOICE Act.

Hensarling, J. (n.d.). SUMMARY OF KEY PROVISIONS OF THE FINANCIAL CHOICE ACT.

The Next Crisis Will be Different from the Last. (2017, February 15). Retrieved from http://www.acting-man.com/?p=34789

Protess, B. (2017, February 03). Trump Moves to Roll Back Obama-Era Financial Regulations. Retrieved from https://www.nytimes.com/2017/02/03/business/dealbook/trump-congress-financial-regulations.html?_r=0