“…we expect to be cutting a lot out of Dodd-Frank because, frankly, I have so many people, friends of mine that have nice businesses that can't borrow money, they just can’t get any money because the banks won’t let them borrow because of the rules and regulations in Dodd-Frank....”
President Donald Trump’s remarks to the initial gathering of his Strategic and Policy Forum, February 3, 2017.
On 12 June 2017, the US Treasury published the first of four reports designed to implement the seven core principles for regulating the U.S. financial system announced in President Trump’s Executive Order 13772 (3 February 2017). The 147-page report (US Treasury 2017) focuses on depositories. Future reports are slated to address “markets, liquidity, central clearing, financial products, asset management, insurance, and innovation, among other key areas”.
Seven years after the passage of Dodd-Frank, it’s entirely appropriate to take stock. Has it been effective? Did it go too far in some areas and not far enough in others?
President Trump’s stated principles provide an attractive basis for making the financial system both more cost-effective and safer. And much of the Treasury report focuses on welcome proposals to reduce the unwarranted compliance burden imposed by a range of regulations and supervisory actions on small and medium-sized depositories that – if adequately capitalised – pose no threat to the financial system. Others, like the recommendation to relax the Volcker Rule, will be more controversial, but nevertheless warranted in terms of a regulatory cost-benefit analysis (Richardson and Tuckman 2017).
Unfortunately, at least when considering the largest banks, our conclusion is that adopting the Treasury’s recommendations would make the financial system less safe. And, it would do so with little prospect for boosting economic growth. At times, the proposals read more like a financial industry wish-list than a desirable and impartial balancing of the country’s needs for both a vibrant and resilient financial system (e.g. The Economist 2017).
It is important to understand that much of the Treasury plan can be enacted by regulators without any legislative action whatsoever. By next year, President Trump will either have replaced, or have had the opportunity to replace, the heads of all the federal depository regulators (the Federal Reserve, Comptroller of the Currency, Federal Deposit Insurance Corporation, and National Credit Union Administration). Consequently, many features of the plan are likely to be implemented.
The Treasury report
The report is far too complex and detailed for us to assess it fully here. The summary tables alone present more than 100 bulleted recommendations in areas ranging from capital and liquidity requirements, to living wills and small business lending.1 Looking at this long list, the most troubling elements of the Treasury's analysis – what will reduce safety the most – are the proposals aimed at relaxing the stringent oversight and capital requirements that have been imposed since the Dodd-Frank Act on a few very large, complex and highly interconnected US banks. (At the end of 2016, only 36 out of some 12,000 depositories had assets exceeding $100 billion, but these accounted for more than three-fourths of assets in the system.)
Perhaps the fundamental problem with the Treasury report is the weakness of its two key premises: (1) that post-crisis financial regulation (particularly Dodd-Frank) has impeded bank lending, making it an important contributor to the weakness of the recovery; and (2) concern that “an excess of capital” in the banking sector “will detract from the flow of consumer and commercial credit and can inhibit economic growth”.
Regulation has not stopped banks from lending
Starting with the recovery, the first question is whether lending has in fact been unusually weak. Figure 1 shows bank lending to the private non-financial sector (including households and businesses) as a percent of GDP in the US (black line), the Eurozone (red line) and the advanced economies as a whole (blue line). In the US, the bank credit ratio declined during and after the deep recession of 2007-2009. But – in sharp contrast to the Eurozone or the broader set of advanced economies – it has now been rising for more than four years. By 2016, credit to GDP exceeded the average reached in 2005, a year of abundant credit supply that helped fuel the financial crisis. Consequently, despite Dodd-Frank’s well-known compliance costs and distortions, there is little evidence that it has held back overall bank lending.
Figure 1 Bank lending to the private nonfinancial sector (quarterly, percent of GDP), 1997-2016
Source: Bank for International Settlements.
The Treasury report alleges constraints at a disaggregated level – that the new regulations are holding back bank lending to small businesses and for residential mortgages. Once again, however, the case is very weak. According to the National Federation of Independent Business’s May 2017 survey, only 3% of small firms viewed their borrowing needs as not satisfied, while only 1% identified finance as their top problem, far below the shares listing taxes (22%), quality of labour (19%), and government red tape (13%) (Dunkelberg and Wade 2017). Similarly, surveys of bank lenders provide little evidence of any new regulation-related constraints on the willingness of banks to lend to small firms since the July 2010 enactment of Dodd-Frank. Overall, we are led to conclude that credit conditions for small business are supportive of economic growth.
The slow recovery of household mortgages presents a stronger case for a constraint on credit supply. Households have delevered substantially since the crisis – lowering the ratio of liabilities to disposable income by 30 percentage points from the 2007 peak – while rising asset prices boosted their net worth to a record 6.6 times disposable income in the first quarter of 2017. Yet, according to the Urban Institute’s Housing Credit Availability Index, the willingness of lenders to tolerate borrower default risk has not recovered to levels that prevailed in the early 2000s, prior to the pre-crisis credit bonanza. In addition, the market for private-label securitizations remains a fraction of its pre-crisis size.
However, we question whether regulations are the primary cause of this hesitance to lend. Having been burned in the earlier private-label securitisation boom, creditors are naturally reluctant to trust the process (e.g. Goodman 2016).
Do banks have too much capital?
What about the Treasury’s second premise – that an “excess of capital” is constraining the supply of bank credit? Neither theory nor experience provide much support for this common industry view. The most fundamental theorem of corporate finance implies that firms should be indifferent about the composition of their financing (e.g. Admati and Hellwig 2014). And, a range of evidence suggests that better capitalised banks lend more (and lend better), not the other way around.
First, rather than boosting costs, higher capital requirements in the aftermath of the crisis were associated with narrower interest rate spreads and lower operating costs for internationally active banks (Cecchetti and Schoenholtz 2014c). Second, as Gambacorta and Shin (2016) show, increases in capitalisation tend to lower funding costs and increase lending volumes. Finally, we have learned at great social cost that when banks accumulate high levels of debt – especially Japan in the 1990s and the Eurozone in recent years – they then lend to zombie firms in a way that hurts, rather than fosters, economic growth (Caballero et al. 2008. Acharya et al. 2016).
Proposals that increase systemic risk
Looking at some of the report’s details, our conclusion is that the Treasury’s new regulatory approach would likely add materially to systemic risk. The prime reason is that they would relax constraints on the small number of systemic intermediaries that account for the lion’s share of US banking assets.
Here are just five examples.
- First, and most important, the Treasury “supports an off-ramp exemption” from stress tests and other prudential standards for banks with sufficient capital, citing the 10% leverage ratio threshold in the CHOICE Act. While adequate capitalisation ought to be sufficient to relax scrutiny of most banks, an off-ramp for supervision of the largest, most complex, most interconnected players would invite renewed gaming of the rules that can make the system fragile. The key point is that capital can be difficult to measure, while the complex activities of some very large banks afford them the opportunity to conceal risk.
- Second, while the Fed’s stress test procedures can be improved and streamlined, the Treasury report proposes changes that would make the tests insufficiently effective (Tarullo 2017).
- Third, the Treasury calls for “recalibration” in cases where regulators have set requirements on the largest US banks in excess of international standards (see Table 3 in the report). ‘Gold plating’ of US regulations is alleged to make US firms less competitive. However, in the post-crisis world, the relatively better capitalisation of top US banks compared to European banks has not prevented them from competing and may even have served as a competitive advantage on the international stage.
- Fourth, the Treasury would remove the FDIC from the review of banks’ ‘living wills’ – the documents that the largest banks must prepare to simplify their resolution in a crisis. Excluding the FDIC from this process is inconsistent with its Orderly Liquidation Authority (OLA) so, absent other changes, it would threaten the credibility of the resolution process for too-big-to-fail banks (Cecchetti and Schoenholtz 2017).
- Finally, the Treasury would relax current or planned liquidity requirements. One example would be to include highly illiquid municipal debt in the definition of high-quality liquid assets.2
We could go on about ways in which the Treasury report downplays important mechanisms to control or anticipate systemic risk and build resilience. For example, the Treasury criticises activities-based regulation for its impact on credit supply, but there is little evidence for that. More important, an activities orientation helps focus regulation on economic function, in contrast to the usual regulation by legal form of the intermediary (which promotes shifting rather than reducing systemic risk).3
The bottom line: only eight years after the end of the worst financial crisis since the Great Depression, the US Treasury has shifted from becoming a leading proponent for enhancing the resilience of the global financial system to an advocate for the private interests of a few financial behemoths in the name of boosting growth. At the same time, the Treasury’s aim to enhance the supply of credit is, at best, unlikely to have much growth impact. We can only hope that, in the future, we won’t look back on the Treasury’s shift as the start of a trend that once again makes our financial system highly vulnerable to severe disruption.
Editors’ note: One of the authors currently serves on the Financial Research Advisory Committee of Treasury’s Office of Financial Research (OFR). An earlier version of this column appeared on www.moneyandbanking.com.
Acharya, V , T Eisert, C Eufinger and C Hirsch (2016), “Whatever it takes: The Real Effects of Unconventional Monetary Policy,” SAFE Working Paper No. 152.
Admati, A and M Hellwig (2014), The Bankers' New Clothes: What's Wrong with Banking and What to Do about It. Princeton, NJ: Princeton University Press.
Caballero, R J, T Hoshi and A K Kashyap (2008), “Zombie Lending and Depressed Restructuring in Japan,” American Economic Review 98(5): 1943-1977.
Cecchetti, S G and K L Schoenholtz (2014a), “Form vs. Function: Regulating Money Market Funds,” www.moneyandbanking.com, 1 May.
Cecchetti, S G and K L Schoenholtz (2014b) “Liquidity Regulation,” www.moneyandbanking.com, 15 September.
Cecchetti, S G and K L Schoenholtz (2014c), “Higher capital requirements didn't slow the economy,” www.moneyandbanking.com, 15 December.
Cecchetti, S G and K L Schoenholtz (2017), “Ending Too Big To Fail: Resolution Edition,” www.moneyandbanking.com, 1 May.
Dunkelberg, W C and H Wade (2017), NFIB Small Business Trends.
Gambacorta, L and H S Shin (2016), “Why Bank Capital Matters for Monetary Policy,” BIS Working Paper No. 558.
Goodman, L (2016), “A Progress Report on the Private-Label Securities Market,” Urban Institute, 8 March.
Richardson, M P, K L Schoenholtz, B Tuckman and L J White (eds) (2017), Regulating Wall Street: CHOICE Act vs Dodd-Frank. New York University.
Richardson, M P and B Tuckman (2017), “The Volcker Rule and Regulations of Scope,” in M P Richardson, K L Schoenholtz, B Tuckman and L J White (eds), Regulating Wall Street: CHOICE Act vs Dodd-Frank, New York University.
Tarullo, D K (2017), “Departing Thoughts,” speech at the Woodrow Wilson School, Princeton University, 4 April.
The Economist (2017), “The Treasury publishes proposals to cut red tape” 15 June.
US Treasury (2017), A Financial System that Creates Economic Opportunities: Banks and Credit Unions. Report to President Donald J. Trump, Executive Order 13772 on Core Principles for Regulating the United States Financial System, 12 June.
 See Appendix B in US Treasury (2017).
 See page 54 of the report (US Treasury 2017), and our earlier discussion in Cecchetti and Schoenholtz (2014b).
 See our discussion in Cecchetti and Schoenholtz (1 May 2014a).