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US regulatory reforms are firmly in President Trump’s sights, which could have significant short and long-term implications for the country’s banking sector, argues Richard Saldanha.
Almost 10 years to the day after HSBC warned of troubles in US sub-prime mortgages by raising bad debt provisions by 20 per cent above expectations1, Donald Trump signed an executive order on 3 February that could potentially unwind much of the post-financial crisis US banking reforms, or at the very least alter the oversight and application of the rules.
The Dodd-Frank Act was introduced in 2010, with one of its goals to give regulators greater oversight of big institutions that are “too big to fail” and to limit the risks they take.
President Trump’s executive order aims to assign core principles for regulating the US financial system while promoting economic growth. Speaking at the signing, US press secretary Sean Spicer said: “The Dodd-Frank Act is a disastrous policy that’s hindering our markets, reducing the availability of credit, and crippling our economy’s ability to grow and create jobs. It imposed hundreds of new regulations on financial institutions while establishing unaccountable and unconstitutional new agency [sic] that does not adequately protect consumers. Perhaps worst of all, despite all of its overreaching, Dodd-Frank did not address the causes of the financial crisis; something we all know must be done. It did not solve ‘too big to fail’, and we must determine conclusively that the failure of a large bank will never again leave taxpayers on the hook.”2
The executive order is backed by former Goldman Sachs’ chief operating officer Gary Cohn, now director of the National Economic Council, who appears to be playing a pivotal role in financial reform under Trump. With other Goldman alumni like Steve Mnuchin, Treasury Secretary, and Steve Bannon, member of the National Security Council, also close advisers to the president, there are fears the interests of the big banks will skew reform away from limiting systemic risk.
Following the signing of the order, Cohn told the Wall Street Journal: “Americans are going to have better choices and Americans are going to have better products because we’re not going to burden the banks with literally hundreds of billions of dollars of regulatory costs every year.”3
For all the opprobrium being poured on the Dodd-Frank regulations, former Securities and Exchange Commission (SEC) chair Mary Jo White warns of the dangers of too much political interference with how the regulator both sets rules and enforces them. She says: “Another current trend pushing against the independence of the Commission are the legislative proposals from Congress seeking to remake our rulemaking process. The House passed a bill just last week that would impose conflicting, burdensome, and needlessly detailed requirements regarding economic matters in Commission rulemaking that would provide no benefit to investors beyond the exhaustive economic analysis we already undertake [SEC Regulatory Accountability Act]. These requirements would also prevent the Commission from responding timely to market developments or risks that could lead to a market crisis.”4
While the pressure for bank deregulation mounts, the prospect of lighter-touch regulation has helped domestic bank shares to power the Dow Jones to a record high this year. In this Q&A, Richard Saldanha, Global Equities Fund Manager, Aviva Investors, looks at the difficulties and risks of rolling back Dodd-Frank regulations along with the prospects for US banks relative to their international competitors.
Trump looks set to roll back much of the Dodd-Frank banking reforms. How likely is he to achieve this?
RS: Whilst the executive order itself does not specifically mention Dodd-Frank, Trump clearly has his sights set on overhauling a large portion of the legislation governing banks. The executive order signals the intent to ease the regulatory burden but it remains unclear just how far it will go. In terms of timelines, I think any significant changes are unlikely until 2018. What will likely pave the way for change is the appointment of senior positions at many of the financial regulatory agencies in the coming year, such as the Consumer Finance Protection Bureau and indeed the Federal Reserve itself. The recent resignation of Fed governor Daniel Tarullo, who was instrumental in the implementation of many financial reforms and who had adopted a tough stance with the banking sector, is symbolic of this potential ‘changing of the guard’.
Repealing Dodd-Frank would need Congressional approval, which would require 60 votes in the Senate. With the Republicans currently holding 52 seats, they would require additional support from the Democrats which would appear unlikely at this stage. That being said, there may be scope for minor adjustments to some of the existing rules.
The sections that are attracting focus for change are around the annual stress tests, specifically the comprehensive capital analysis and review (CCAR), which could potentially free up more capital. Another area of focus could be the qualitative aspects which evaluate plans for managing capital and risk. It is still early days with much speculation over what might change. But it is more about the direction of regulation and the executive order signals that intent.
Haven’t we been here before?
RS: There is a danger of rolling back too much and ending up in a similar situation to the run up to the global financial crisis of 2008. It’s important to remember that the reason Dodd-Frank was established was in order to avoid a repeat of the financial crisis and from that perspective regulators have been successful, with the major banks far better capitalised as a result. In any event, bank chief executive officers are not looking for a complete overhaul of the regulations. There are some aspects that require them to hold more capital than they feel is sufficient, which they would like relaxed.
Is the assumption that regulation will be scaled back priced into bank shares?
RS: President Trump’s pro-growth agenda has reinforced the reflation investment theme, helping drive the recent rally in banks. Yield curves were already steepening in the run up to November’s election and have steepened further on expectations US interest rates will climb faster than anticipated. This has provided a much-needed boost for the net interest income for banks, which had been flagging somewhat previously during the extended period of low rates. In terms of deregulation, I’d say at this stage this is only moderately priced into bank shares given the uncertainty around the exact nature and timing of any changes. The key driver for the bank share prices will likely remain interest rate expectations.
The signing of the executive order on 3 February is important in the sense it signals this is a priority for the Trump administration. The appointment of new regulators, such as nominee Jay Clayton as chair of the SEC, may ease the path for the regulations Trump wants. The heads of the Federal Reserve, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency and Commodity Futures Trading Commission are all due to stand down by February 2018. So Trump will have the opportunity to appoint four new leaders to US financial regulatory bodies in the next twelve months.
Are there any potential negatives from the Trump agenda for the banking sector?
RS: There is an argument that increased US protectionism would hit global growth and subsequently capital market activity, which would be a clear negative for banks. Markets have very much embraced the pro-growth aspect of Trump. Protectionism is the elephant in the room that could affect banks across the world.
What does this mean for European banks?
RS: European bank shares also received a boost on the announcement of the executive order. For those with US operations (which are subject to the CCAR stress tests), any rolling back related to the tests would be beneficial. It’s hard to see any meaningful deregulation taking place for the European banking sector, particularly given we are still awaiting on the final agreement from the Basel committee around what the new set of standards (Basel IV) will be. With this potential divergence in the regulatory backdrop in the US and Europe, getting global agreement on banking regulation may prove even more difficult.
Longer-term, are you concerned that the easing of Dodd-Frank increases systemic risk?
RS: There have certainly been concerns voiced amongst Democrats suggesting it would increase systemic risk. But it will depend on the extent to which rules are scaled back and the approach of the regulators. US banks are far better capitalised than they were in 2008. The market would be less concerned if there was a slight easing of certain rules given the strength of the banks’ balance sheets. Systemic risk becomes an issue if reform becomes too extensive.
What about the effect on enforcement?
RS: Again this very much boils down to how big the rollback of regulations is; having said that there must be a risk there is not as much financial oversight under the new regime, though the markets seem quite sanguine about this risk, at least for now.
The nominations for regulatory positions and the final appointments will be telling. There is little doubt the Democrats will push back on some of the planned reforms. But if you are a chief executive officer of a big bank, you are going to be looking more favourably about the noises that have been coming from Trump and his advisors.
Would you expect US bank capital to drift lower after Trump’s proposed changes?
RS: I think that it is more about the level of bank capital held not being increased further than falling significantly under any relaxation of the Dodd-Frank rules. In time, there may be more breathing space for the banks and more opportunities to return capital to shareholders.
So there is little chance of another financial crisis?
RS: There is always risk, but it is important to recognise that US banks are in relatively good health at this point in time, certainly from a capital perspective.
Will any European banks re-domicile out of Europe to the US?
RS: It depends on the degree of scaling back in the US. If the changes are marginal, then the likes of BNP Paribas or Deutsche Bank are unlikely to suddenly move large swathes of their operations to the US. Many of the large European banks have US operations that are subject to stress tests and the CCAR rules, so any relaxing of these rules will help these banks.
Is an easier bank regulatory regime more favourable for equities than credit?
RS: There was a much bigger reaction to the announcement of the executive order in the equity market than among debt investors - this is likely to do with investors positioning for increased capital returns. The prospect of increased dividends and share buybacks would certainly be more positive for equities than credit. Having said that, there is an argument that regulatory easing could be positive for both asset classes if banks become more profitable and the US economy generates more growth. But that would be more of a longer-term story.
1 Source: BBC, US housing slowdown knocks HSBC, 8 February 2007
2 Source: The White House, Press Briefing by Press Secretary Sean Spicer, 3 February 2017
3 Source: The Washington Post, Trump to order regulatory rollback Friday for finance industry starting with Dodd-Frank, 3 February 2017
4 Source: Securities and Exchange Commission, The SEC after the Financial Crisis: Protecting Investors, Preserving Markets, 17 January 2017
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 16 February 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.