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Monday, February 13, 2017

Trump’s Executive Order on Finance Might Just Work Out Best

By Roy C. Smith

Mr. Trump’s executive order on Dodd Frank and financial regulation announced on Feb. 3 doesn’t seem like much of a shake up – all it did really was ask for a study -  but it may turn out to be the easiest way to address his tough anti-bank campaign promises, yet still ease the way for the financial industry to finance growth.

As a candidate Mr. Trump pledged to “dismantle” Dodd Frank and “break up the banks. “ The Republican Party platform on which he was elected also called for reinstituting Glass Steagall, the 1933 law that separated banking from securities activities until it was repealed in 1999.  Since the election, attention also has been drawn to Congressman Jeb Hensarling’s proposed Financial CHOICE Act that would enable large banks to opt out of Dodd Frank under certain circumstances.  And, during his confirmation hearings Treasury Secretary nominee Steve Mnunchin said the government might adopt a “ringfencing” plan similar to the one the UK approved to minimize systemic risk.

It now looks like none of these are likely to happen, but instead a new Trumpian solution will emerge that will fix the problems posed by the both “reckless banks” and the “disastrous” legislation enacted by the Obama Administration.

Critics of the 2010 Dodd Frank Wall Street Reform Act agree that it is too big, cumbersome and costly and it has negatively impacted economic growth by limiting corporate access to credit. Its supporters claim it is a necessary effort to prevent future bailouts of banks and to reduce systemic risk and misconduct in financial services.

The structure of the Dodd Frank law is to require each of nine financial regulatory agencies (headed by presidential appointees) to adopt 390 new “rules” that implement the various provisions of the statue.  Only about 80% of these new rules have been adopted so far; it takes time to write them, wrestle with lobbyists and industry opinions and finally get them in place. But the teeth of the law are in these rules. Change the teeth and you change the law.

The Trump plan apparently was devised by Gary Cohn, ex Goldman Sachs COO and now Chairman of the National Economic Council. No one knows more about the costs and benefits of Dodd Frank than Cohn who has spent six years supervising its implementation at Goldman Sachs and adapting to its strategic constraints. No doubt Cohn has collaborated with Jay Clayton, a respected securities lawyer at Sullivan & Cromwell, and newly designated head of the SEC.

These men know that there are some good and useful parts to Dodd Frank that strengthen the financial system. They also know that the financial industry has spent in the area of $35 billion setting up systems to comply with Dodd Frank, and they don’t want to see the whole regulatory structure uprooted and replaced with something new that they would have to adjust to all over again. They would rather see existing rules changed to eliminated the unnecessary, ineffective and burdensome parts while preserving the basic framework they have become used to.

The Trump executive order requires the Treasury Secretary (who is chairman of the Dodd Frank created Financial Stability Oversight Council) to report back within 120 days as to which of the existing myriad outstanding financial regulations (not just those from Dodd Frank) support Mr. Trump’s new “Core Principles” for financial regulation, and which do not. These Core Principles include many of the regulatory objectives of Dodd Frank, but, unlike that law, they also require that the regulatory system not impair economic growth or weaken financial markets.  

Some of the offending parts of existing regulations can be fixed by having new appointees change the implementing rules. Other parts may require a legislative amendment to Dodd Frank, which, if technical or only involve obscure details, could be inserted into some other law likely to be passed with the Republican majority. The basic idea, however, is to fix what you can in a timely way, but avoid a big battle in Congress (that could take 60 votes in the Senate that Republicans don’t have) to repeal the old law and to replace it with something new.

Even so, a lot of work will be required in the next 120 days to identify the offending, non-Core parts of all existing financial regulation, and then a lot more work and time will be required to write up the rule changes and get them implemented.  The net result is probably that the smaller banks will be given some well-deserved relief on the applicability of the Dodd Frank to them, and the bigger ones will get relief on rules affecting trading, derivatives, compensation and consumer financial protection, and on some of the burdensome compliance and reporting requirements.

But the banks will still be subject to the tough capital requirements of Basel III, and to the qualitative stress tests applied by the Federal Reserve. The Trump plan will not be a return to the status quo ante 2008, but it should help the industry on the cost side and allow more lending to companies seeking credit.

Indeed, it might just be about right. 

Friday, February 10, 2017

Financial Reforms Will Favor US Banks

By Roy C. Smith

Stock markets have been especially kind to US and European banks since the Trump election, and last week’s announcement of an executive order to reduce financial regulation added a further boost. But, regulatory relief will be slow in coming and may not be as much as markets seem to expect. Still, the net effect should widen the competitiveness divide between the large US banks over Europeans.

The Trump approach to financial regulatory reform is as chaotic as everything else.  In the past year, he has said he wants to dismantle Dodd Frank, to break up the banks, and to restore Glass Stegall. He has also said he supported the Financial CHOICE Act, for which Congressional hearings will soon begin. But, on February 3rd he took a different (or an additional) approach by issuing an executive order to establish “core principles” of financial regulation, which include remaining tough on the banks, but eliminating ineffective regulation and that not vetted by rigorous cost-benefit analysis.

That’s been enough to get markets thinking that Dodd Frank will be defanged, new regulations (and litigation) will be halted, rules limiting proprietary trading and derivatives will be loosened, and the whole compliance process will be made less cumbersome, costly and time consuming.  For the first time in years, all but one of the six leading US capital market banks are trading above book value (Citigroup is still at 78% of book). One analyst recently predicted that these banks will have $100 billion more to distribute to shareholders through dividends or buy backs because of regulatory relief.

Others, experts in Congressional and regulatory procedure, say not to hold your breath.

The revived effort by Jeb Hensarling, chair of the House Financial Services Committee, to enact his Financial CHOICE Act that substantially amends Dodd Frank and provides an opt-out from it, will require 60 votes in the Senate that Republicans don’t have.

Further, Mr. Trump’s heralded executive order, which aims to reduce the burden of the 400 new rules that Dodd Frank required regulatory agencies to issue, is at least two years from any significant impact. Rule changes are bound by administrative procedure and are subject to public comment and legal challenge in the courts. In any case, it takes time to sift through all the Dodd Frank rules and all the others on the books, as the executive order requires, and to figure out what to do about them.

How much relief this might provide large banks is unclear. Most of the regulatory weight of financial reform since the 2008 crisis is concentrated in the much-tightened Basel III minimum capital requirements, which Mr. Trump will not abandon, and in the qualitative stress tests conducted by the still independent Federal Reserve. 

Still, most observers believe that the US regulatory burden will not increase, starting from now, and is likely to be reduced over time by the Trump government, though the amount of benefit this will produce may be less than the markets now assume.

But any relief is better than none, and will free up funds with which banks can compete for market share and for shareholder investment with their shrinking number of European rivals.

More important than regulatory relief to the banks, however, is the positive market sentiment that expectation of Trump economic policies has brought. Higher US growth rates, more capital investment, more mergers and larger project financings than would have occurred under a Hillary Clinton government, and certainly more than can be expected in an EU split by political divisions and still stuck in a low growth mode.

The three remaining European capital market banks (Barclays, Deutsche Bank and Credit Suisse) have benefitted from the Trump rally too, but still lag their American competitors. Credit Suisse now trades at 68% of book value, up from 44% in the summer; Barclays is at 58%, up from 34%, and Deutsche Bank, is only at 37% of book, up from a miserable 23% last September.

None of these banks can expect much from US regulatory easement, and instead, are stuck with adapting to a gloomy European political and economic outlook, Brexit, ringfencing, balance sheet and income statement problems, and continuing worries about US litigation for misselling mortgaged-backed securities, money laundering and sanction-breeching, which led to Deutsche Bank’s full page apology to shareholders last week for another massive loss.

American banks will likely assume that the improving economy and the expectation of regulatory relief that has driven up their stock prices removes the pressure on them for any sort of strategic realignment – that is, to separate themselves into two businesses, commercial banking and investment banking, rather than continue to try to operate both under one roof. It is doubtful that this strategy is correct, especially for Citigroup and Bank of America, but the sharp rise in their stock prices has kept this wolf from their doors, at least for now. 

European banks, on the other hand, continue under pressure from the market to split up or back away from capital market activity which has proven so difficult for them to master.  More positive developments from the US will widen the gap between US and European capital market banks. But the Europeans still in the game believe they have little choice but to remain in it. At least for now.

Published in eFinancial News, 2/10/2017

Wednesday, February 1, 2017

Where’s Trump Going on Consumer Financial Protection?

Ingo Walter

            Before and after enactment of the Dodd-Frank legislation in 2010, concerns were raised that consumers often lacked the knowledge to evaluate and make informed decisions about financial services.  Some of the most important involve home mortgages, car loans, asset management, retirement planning, household credit for major durable purchases and credit lines for ongoing household expenses, life and nonlife insurance to keep a family secure, and many more. In the past, the government and employers often made some of the most important financial decisions on behalf of households - for example by providing Social Security or defined-benefit employee retirement plans. Today, households are mostly on their own.

Not such a bad thing, with plenty of financial products and competitors from all kinds financial firms to choose from. But with time financial products have become more complex and less transparent, and a there is bewildering range of options being pitched. Often financial salespeople are under heavy pressure to cross-sell, leading to unneeded new accounts or up-sold services, sometimes attached to an array of embedded and sometimes undisclosed fees. Certain products, such as some kinds of variable annuities, can be almost impossible for consumers and even salespeople to value and identify the associated risks.

And it’s not too late to remember the mortgage “affordability” resets, embedded options and prepayment penalties offered to eager households back in the glory days of the mortgage boom a decade ago. The financial crisis soon placed many of these issues in sharp relief in the US housing market’s mortgage-origination “fee machine,” and through financial contagion its contribution to global systemic risk.

As in any market, there are buyers and sellers, and it’s in the interest of both to come to market fully informed about the price and the exact terms of what is being bought and sold. There are always mistakes being made, but the playing field should be as level as possible for the market to do it’s work – wealth creation, rather than wealth redistribution.

The argument for regulatory intervention is that consumers frequently suffer from market attributes that are stacked against them, so that caveat emptor is an inappropriate model for conduct in the marketplace. The basic sources of consumer disadvantage are found in lack of education and financial skills, lack of transparency in financial products and services, lack of fiduciary responsibility on the part of financial services vendors, and exploitation of vendor conflicts of interest.

Few would argue that consumers should escape the need for proper due diligence, or escape the consequences of their own errors. Moral hazard alone makes an excessively robust consumer safety net untenable. There should be plenty of holes in the safety net. But a systematically biased playing field that aggressively steers consumer choice, provides incomplete and biased information, and creates conditions of financial exploitation is no less toxic. It drains trust from the system. Without trust, neither financial efficiency nor stability can be assured – and ultimately encourages excessive regulation when the political costs get too high. So there is a legitimate argument that both remedial and preemptive improvements in some key dimensions of consumer finance are a good idea.

First, consumers need to be financially literate in order to make well-informed choices in complex financial decisions. There have been some severe gaps. Consumers often do not understand fundamental financial concepts such as compound interest, risk diversification, real versus nominal values, and even the difference between stocks and bonds. Indeed, the evidence suggests that consumers   with higher levels of financial literacy plan better for retirement, while those with lower levels of literacy borrow more, save less, and have more trouble repaying their debt, making ends meet, planning ahead, and making important financial choices.

But seriously, who’s going to cut down on time devoted to their jobs and recreational priorities to take Adult School classes in basic finance? And sometimes too much information is provided and leads to information overload, which can cause consumers to focus on only a few pieces of easily understood information, not necessarily the key aspects for complex financial decisions – relying instead on a few simplified explanations.

There are of course counter-examples. One is lapsed life insurance that can be surrendered with total loss of capital, sold back to the insurance carrier at a substantial discount, or sold to third parties for securitization and marketed to investors - sometimes called “death bonds” or “mortality bonds”.  Another example is long-term care insurance, which can be an expensive but rational choice for consumers, or a combination of life insurance and long term care insurance to lower the cost.  Consumers sometime seem to display remarkable clarity in thinking about the options, even though pricing and disclosure specifics may remain obscure.

Still, consumers can be overly optimistic in interpreting information in a way that that helps lead them to a desired if irrational conclusion. And there’s concern that some financial firms purposely design and proactively advertise products to mislead consumers about benefits, leaving “financial health warnings” to the fine print. Some classes of consumers - such as older people preoccupied with life’s other challenges, minorities and women - may be particularly vulnerable to aggressive marketing practices for financial products and leave consumers disproportionately on the receiving end of exploitation. And it’s been argued that complex financial products survive in the marketplace because they enable cross subsidizing sophisticated consumers at the expense of the unsuspecting. Regulatory intervention in that context will tend to redistribute income away from sophisticated customers, who prefer less consumer protection.

The underlying argument is that fairness embodies more than moral or ethical content in the financial architecture. Failure to provide equitable treatment undermines confidence in the system and impact liquidity, efficiency and growth. It distorts financial flows on the part of ultimate sources and uses of funds, and undermines the political legitimacy of financial intermediaries and those who regulate them. So sensible government intervention is needed as a matter of the public interest.

Dodd-Frank and the Consumer Financial Protection Bureau

This is the logic behind the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, which created   the Consumer Financial Protection Bureau (CFPB) as an independent unit within the Federal Reserve System. Dodd-Frank was mainly about financial stability and systemic risk. But “consumer protection” in the title signaled the its political centrality in setting out the future rules of engagement.

Dodd-Frank’s consumer protection legislation covers depository institutions with assets exceeding $10 billion, mortgage lenders, mortgage servicers, payday lenders and private education lenders. It does not cover automobile financing.

The legislation created the Consumer Finance Protection Board (CFPB) with a mandate to aid consumers in understanding and using relevant information and shielding them from abuse, deception, and fraud by ensuring that disclosures for financial products are easy to understand. It is also mandated to conduct consumer finance research and provide financial literacy education. It has the authority to set rules under existing consumer financial law and take appropriate enforcement action to address violations. It is charged with collecting, investigating, and responding to consumer complaints. And it has a mandate to ensure that suitable financial products and services are made available to consumer segments and communities that have traditionally been underserved.

The CFPB itself is an entity of the Federal Reserve System, and its budget is self-determined and funded out of Fed resources, not by Congressional appropriation – thereby offering some protection against inevitable lobbying pressure. It is managed by a Director (currently Richard Corday) who is appointed by the President   with the advice and consent of the Senate, serving a five-year term and who (like that Chair of the Federal Reserve Board) can be dismissed only “for cause.”

The Financial Choice Act

The consumer protection provisions of Dodd-Frank and the CFPB were controversial from the start, with criticism spanning a range of issues from the constitutionality of its mandate and the heavy hand of overregulation to the “blank check” funding through the Fed and the early cases demonstrating its allegedly excessive use of enforcement powers. Much of the criticism was concentrated in the draft Financial Choice Act (FCA) tabled by Republicans on the House Committee on Financial Services in June 2016..There are two major themes in this proposed CFPB revision:

The first is governance and accountability. As a unit of the Federal Reserve System, CFPB governance was considered both indirect and lacking a clear public mandate and political accountability. Moreover, its budget (close to $1 billion in fiscal 2016) is thought to escape the kinds of checks and balances that apply to other Federal agencies. The Financial Choice Act would broadly extend to the CFPB the kinds of governance, accountability and budgetary appropriations that apply to other federal agencies.

The second key issue is the matter of consumer choice and cost. The CFPB is thought to preempt free consumer choice, transferring to CFPB bureaucrats key decisions about which financial products will be available and to whom, what product information needs to be disclosed, and how they are marketed and priced. The argument is that the CFPB has reflected a retrograde turn away from the market economy towards increased paternalism of the state. It highlights presumptive cuts in access to financial services to the un-banked and under-banked, increases in the cost of financial services, violates consumer privacy, and harms small businesses that rely on consumer financial products.

That said, convincing evidence suggests that tough consumer protection measures can in fact work. Take for example the 2009 Credit Card Accountability and Responsibility and Disclosure (CARD) Act, which capped credit card penalty fees that card issuers were using to make up for lost revenues during the recession.

A careful study of the CARD Act’s impact found that the reduction in fee revenue from cancelled "over-limit" and late fees did not in fact lead to banks increasing credit card interest rates or significantly raising other fees in the period through 2015, nor did it reduce access to credit for US households. In combination, the Act reduced cut the cost of financial services to consumers by about $11.6bn annually.

The Financial Choice Act proposes a range of specific reforms that would fundamentally change the operations, governance, accountability and funding of the CFPB, although it does not propose to scrap it.

Where Should the Trump Administration Be Heading?

Where the Trump Administration will come down on consumer financial protection and the fate of the CFPB and the Financial Choice Act is uncertain. But at least the FCA offers a considered road-map for change, one which deserves to be debated. It seeks to pare away some of the Dodd-Frank provisions considered superfluous or counterproductive, and increase the accountability and budgeting process of the CFPB to align it to governance of other important federal agencies, while increasing accountability to elected officials.

It is hard to argue against political accountability and financial discipline. Still, in a system driven by heavy lobbying and financial contributions by those who stand to gain or lose from consumer protection measures, the survival and impact of Financial Choice Act proposals, if enacted, are difficult to gauge. It is a major, highly complex exercise in cost-benefit analysis – one in which both costs and benefits are often obscure and second-best solutions are often welcome. Inserted into the coming overheated, lobbyist-driven political debate, it is not hard to imagine that consumer interests will once again come at the end of the line.

Of course there is always the threat of over-regulation, but there is also value in helping consumers gain financial literacy, in improving our understanding of how consumer financial markets work, in helping people access and use relevant  information, and in protecting them from abuse, deception and fraud.

Fintech is the wild card in the game. Several dozen players ranging from start-ups and proof-of-concept players to established veterans seeking “unicorn” status by disrupting a retail financial services considered overdue for disruption. They range from marketplace lending to robo-advising, from financial aggregation to retail remittances, from e-brokerage to retirement planning. As these “direct-connect linkages take root, some of the key household disadvantages in finance could melt away – especially as new generations of consumers come on the market – and the case for consumer finance regulation may weaken.

On the other hand, the legacy players weren’t born yesterday, and a wide range of fintech initiatives have already been internalized by the established financial intermediaries – even the independent “disruptors” themselves have found it opportune to link-up with fintech upstarts in joint ventures and as attractive acquisition targets. The fintech dynamic has its own ways of tilting the playing field and generating new forms of conflicts of interest. Good new or bad news? Some of both, no doubt, and time will tell. What is certain is that consumer financial protection will be a moving target.

What’s also certain is that there will continue to be many “sticky fingers” in finance, amply reflected in the waves of wholesale and retail banking scandals since the financial crisis. If nobody’s watching the store, bad things happen. The recent Wells Fargo case involving consumer cross selling - a core strategy deeply ingrained in Wells Fargo’s history, culture and incentive systems - shows how easily a good institution and good people can overstep even the most basic trust and fiduciary constraints in dealing with “soft target” consumers.

Indeed, in a highly competitive financial services market, profit often lurks in the shadows. Retail finance is particularly vulnerable to questionable financial practices given its gaps in information and understanding. So it is surely in the public interest to focus on remedies for market imperfections and professional malfeasance as they appear, and if possible preempt them. It may not be the “best” and most efficient approach, but “second best” can also leave the world better off – as always, the devil is in the details.

Whether the Trump administration and the Congress ultimately chooses the “high road” to consumer financial protection remains to be seen.